Six Thoughts on Taxes and Small Business

This morning I appeared at hearing of the Select Revenue Measures Subcommittee of the House Ways and Means Committee on “Small Businesses and Tax Reform.” My full testimony, “Tax Policy and Small Business,” is available here.

My opening statement:

America’s tax system is needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s increasingly unpredictable. And it fails at its most basic task, raising enough money to pay our government’s bills. For these reasons, the time has come for fundamental tax reform.

Such reform could have far-reaching effects on every participant in the economy, including small businesses. To provide a foundation for thinking about these effects, my testimony discusses basic facts about the relationship between tax policy and small business. I make six main points:

1. Today’s tax code generally favors small businesses over larger ones. Provisions such as Section 179 expensing, graduated corporate tax rates, and special, low capital gains taxes benefit businesses that are small in terms of investment, income, or assets.

2. Many small businesses also benefit from the opportunity to organize as pass-through entities. S corporations, limited liability companies, partnerships, and sole proprietorships all avoid the double taxation that applies to income earned by C corporations.

3. The benefits of organizing as a pass through are not limited to small businesses. Some large businesses adopt these forms as well. Although these large firms account for a tiny share of pass-through entities, they represent a substantial fraction of pass-through economic activity. For example, only 0.3 percent of S corporations had revenues above $50 million in 2005, but they accounted for more than a quarter of S corporation income. The situation is even more extreme with partnerships. Only 0.2 percent had revenues above $50 million, but they accounted for 57 percent of partnership income. Lawmakers should therefore take care not to assume that all pass throughs are small businesses.

4. Small businesses face disproportionately high costs in complying with the tax code; they are also more likely to understate their income and underpay their taxes. High compliance costs thus disadvantage responsible small businesses, while the greater opportunity to evade taxes can advantage less responsible ones.

5. An ideal tax system would collect enough revenue to pay for government services while minimizing distortions to economic activity. To the extent possible, economic fundamentals, not tax considerations, should drive business decisions about organizational structure. By treating pass throughs and C corporations differently, our current tax system deviates from that ideal.

6. In discussing reform proposals, it is important to distinguish between businesses—a broad category that includes pass throughs—and corporations, which generally means C corporations. Many tax reform proposals would reduce business tax preferences and use the resulting revenue to cut corporate income tax rates. Such revenue-neutral reforms could lessen the disparity in tax treatment between pass throughs and C corporations. Pass throughs would see their tax burden increase (since they would lose some tax preferences but not benefit from the rate reduction), while C corporations would, on average, see their taxes decline.