The Taxation of Small Business: Tax Reform

Introduction and Overview

In recent research, Ike Brannon and I reviewed the implications of the fact that a large number of individual tax returns each year report that some portion of their income comes from owning, operating, or participating in a business.  In 2009, nearly 23 million returns reported some amount of business income.^[1]  The tax code does not tax sole-proprietorships, partnerships, or S-corporations as businesses.  Instead the income is “passed through” to the individual’s tax return to be taxed; thus these entities are referred to as “pass-through” entities.  These pass-through entities play an outsized role in the U.S. economy. Together, these three types of entities reported revenue of nearly $13 trillion in 2008, 86 percent of our $15 trillion economy.[2]

The current tax rates affecting these small businesses are set to increase in 2013 unless Congress and the administration act to extend the so-called “Bush tax cuts” of 2001 and 2003 for another year. The expiration of these tax rates would not only increase the tax bills for millions of Americans but it will also cause taxes to go up on millions of small businesses.  We estimated that the impact of raising the top two tax rates would be severe, with output falling by roughly the current rate of economic growth, and the unemployment rate jumping to nine percent.  Over the longer term there would be permanently impaired incentives for small businesses to hire and invest.

However, there are several proposals – notably the Bowles-Simpson Commission and the Domenici-Rivlin Commission – that would lower marginal tax rates.  Such a reduction would have beneficial impacts on the small businesses and entrepreneurs taxed as pass-through entities.  The purpose of this short note is to quantify those impacts.

Small Business Impacts of Tax Reform

Under current law, the top marginal tax rate in 2013 will be 44.6 percent.  This consists of the statutory rate of 39.6, the so-called “Medicare tax” of 3.8 percent on net investment income and the implicit tax of 1.2 percent created by the phase-outs of personal exemptions and itemized deductions.  Alternatively, consider the possibility of a comprehensive reform that sets the top rate at 28 percent.[3]

Using the same methods as the  earlier research, the decline in the top effective rate would raise the probability that a small business entrepreneur would add to payrolls by roughly 48 percent – a significant impact.   Similarly, for those firms that do manage to hire, the growth in payrolls would be enhanced by over 14 percent.  An implication of this is that tax reform that is in principle directed at higher income taxpayers would benefit workers by hiring and paying more.

In the same way, the tax reform affects incentives for capital expenditures, raising the probability that a small business undertakes expansion by nearly 40 percent, and augmenting the capital outlays of those that do by 54 percent.  As these expansionary incentives are put in place, the demand for capital goods will rise – a fundamental of strong economic growth.

Thus, tax reform can have very beneficial effects on an important sector of the economy.  According to the Tax Policy Center, over 70 percent of all tax filers in the top two brackets report at least some business income on their return, and over one-third of all income in those two brackets represents business income.[4]  In addition, nearly twenty five million Americans work for small businesses affected by the top rate, according to data from the Joint Committee on Taxation (JCT) and the National Federation of Independent Businesses (NFIB).[5] That represents more than one out of every six people currently employed.