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Friday, January 14, 2011

Small Business and the Expiration of the 2001 Tax Rate Reductions: Economic Issues

Jane G. Gravelle
Senior Specialist in Economic Policy

At the end of 2010, the lower income tax rates provided in 2001 were to expire. The President had proposed to extend most tax cuts, but to continue higher rates for couples with income over $250,000 and singles with income over $200,000. The most important element of this proposal, as measured by revenue effect, is allowing the top rates of 33% and 35% to expire, when they would have risen to 36% and 36.9%. P.L. 111-312, enacted in December 2010, extended all tax cuts for two years, through 2012, delaying the consideration of which tax cuts to retain.

Some critics of allowing the tax rates to rise express concerns about possible negative effects on small business owners’ hiring and the dampening effect on job creation. This view is buttressed by a popular conception that small businesses are responsible for the majority, perhaps the vast majority, of new jobs.

The first issue addressed is how well retaining the lower levels of the top two rates target small business. Two aspects of targeting are considered: the fraction of small businesses affected by the rate changes and the fraction of revenue gain accruing to taxpayers other than these small businesses. The results suggest that only a small fraction of businesses would be affected, around 2% to 3%. They also suggest that 80% of the reduced taxes are likely to accrue to non-businesses income and almost 90% to either non-business income or businesses without employees.

The claim that small businesses are the primary creators of jobs is based on research published originally in the 1980s. More recent research has revealed some methodological deficiencies in these original studies and suggests that small businesses contribute only slightly more jobs than other firms relative to their employment share. Moreover, this differential is not due to hiring by existing small firms, but rather to startups, which tend to be small. Some critics also question whether small business jobs should be encouraged because they tend to be lower paid, with fewer benefits and more turnover. Yet, small businesses may offer employment to workers with less education or other characteristics that lead to difficulty finding employment with larger firms.

In addition to targeting efficiency and job creation issues, there is uncertainty about the effects of taxation on small businesses. An extensive literature suggests that higher taxes have no effect or actually encourage self-employment. Researchers speculate that higher taxes may lead individuals to select self-employment because the opportunities for tax evasion and avoidance are greater. In addition, taxes reduce risk (the variance in return) and greater variance in earnings likely occurs in self-employment. Evidence of effects of taxes on existing firms’ hiring is limited.

Perhaps the most important issue concerns job creation as a policy justification. In the long run, there is no need to address job creation as the market economy naturally generates jobs (although targeted programs, such as those for disadvantaged workers, may improve efficiency). In times of recession, the government may need fiscal stimulus, but the purpose of this stimulus is generally to increase aggregate demand. The most effective approaches are direct spending and tax cuts and transfers to lower income individuals who are more likely to spend. Tax cuts for high income individuals or business are less likely to be spent and are less effective as a stimulus.

There may be justifications for favoring small business, although small businesses, especially businesses owned by high income individuals, are already subject to favorable treatment. Tax policy might be most appropriately formulated in the light of any imperfections in the economy which justify preferential treatment.

Date of Report: January 6, 2011
Number of Pages: 22
Order Number: R41392
Price: $29.95

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