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September 21, 2011
The Myth of Mom-and-Pop Businesses

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By Martin A. Sullivan --

It is common practice for politicians and the press to use the term "small business" to describe passthrough businesses -- sole proprietorships, partnerships, and subchapter S corporations. From the perspective of economics, this highly inaccurate label is of little significance because -- despite all you may have been hearing -- there is nothing particularly wonderful about small business that it deserves special treatment from the federal government. So if you want to provide tax relief to passthroughs, the effects on the overall economy will be pretty much the same if those passthroughs are all corner stores or a handful of mega-businesses.

But politics has far more to do with emotion and perception than economic reality. Small companies are the darlings of the business world. They have semi-sacred status in the American political economy, like family farmers and homeowners. They are doers. They are entrepreneurs. Public sentiment for small business is far more favorable than for large business. When it's David versus Goliath, human nature inevitably draws us to root for the little guy. It almost goes without saying that any public relations effort by business will place as much emphasis as possible on the smallness of it.

And so the best defense of preventing the top two individual tax rates from returning to 36 and 39.6 percent is that it would be an assault on small business. It is true that the rate change would hurt small businesses. But a new study from Treasury economists using 2007 data makes clear that the magnitude of this effect is not nearly as large as the defenders of rate cuts would like the public to believe. (See Matthew Knittel, Susan Nelson, Jason DeBacker, John Kitchen, James Pearce, and Richard Prisinzano, "Methodology to Identify Small Businesses and Their Owners," Office of Tax Analysis, Technical Paper 4, Aug. 2011, Doc 2011-17260 or 2011 TNT 154-18.)

Figure 1. High-Bracket Small Business Income Is Not a Majority of
Small Business Income or High-Bracket Passthrough Income

What exactly is a small business? There is no one answer. The Small Business Administration has a long and convoluted definition that varies by industry and sometimes uses gross receipts and sometimes uses number of employees. For their study, Treasury economists had access to a treasure trove of tax return data, but even that did not include the number of employees. So they could use only gross receipts to determine business size. They chose $10 million of gross receipts as the threshold. This seems reasonable. According to Census Bureau data for 2007, employers with between $7.5 million and $10 million of gross receipts had an average of 52 employees. (See Table 3, Receipt Size of Employer Firms, 2007, Anybody who wants to challenge the Treasury study would be hard-pressed to find a more defensible alternative.

Figure 2. Small Business Employer Income as a
Percentage of High-Bracket Income
(Dollars in Billions)

Fascinating Statistics

The left side of Figure 1 shows that only 44 percent of small business income ($183 billion out of $412 billion) would be affected by rate changes. Or to put it differently, 56 percent of small business would get no benefit from the rate cut.

By comparing the two top rectangles of Figure 1, we can see that only 47 percent ($183 billion out of $387 billion) of passthrough business income affected by the rate change is small business income.

The right side of Figure 1 shows us that a whopping 93 percent of income from large and midsize passthrough business flows to high-bracket taxpayers.

If the goal of policy is to help small business, Figure 2 shows how absurd it is to use high-end rate cuts to further this effort. Only 8 percent of all the income that would benefit from keeping rates low is small business income.

There are economically defensible reasons for keeping high-income rates from rising. For example, because wealthy taxpayers do the lion's share of saving and investing in this country, it makes sense from the perspective of supply-side economics to prevent their rates from rising. Of course, this has to be weighed against some people's concerns about fairness and everybody's concern about larger deficits. What is clear from the Treasury data is that the defense of small business should not be the basis for any decision about tax rate changes on the wealthy.


This article is a sequel to "Should We Raise Taxes on Wealthy Employers?" Tax Notes, Sept. 5, 2011, p. 979, Doc 2011-18511, or 2011 TNT 172-2. The prior article provides more discussion about the details of the underlying data from the August Treasury study. High-bracket taxpayers in this article are all individual taxpayers in 2007 facing the 33 and 35 percent rates and half of taxpayers paying alternative minimum tax at the 28 percent rate. The inclusion of the last category is meant to account for the high-income taxpayers who will no longer be subject to the AMT if regular tax rates rise. Because there is no size breakdown in the Treasury study of nonbusiness passthrough entities, Figure 1 excludes data on those passthroughs.

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