Tax Reform and Taxation of Small Business

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Abstract

A tax code that is fair, simple, and conducive to economic growth is in the interest of all Americans and of all businesses, large and small. In this testimony, Toder addresses the ways in which the tax system affects companies organized as small businesses, compared with larger enterprises. He discusses provisions of the current tax law that affect the relative incentive to organize economic activity within smaller or larger business enterprises and between different forms of enterprises and outlines how selected tax reform proposals would affect those choices.

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Testimony

Chairman Baucus, Ranking Member Grassley, and Members of the Committee:

Thank you for inviting me to testify today on tax reform and small business. A tax code that is fair, simple, and conducive to economic growth is in the interest of all Americans and of all businesses, large and small. My testimony will address how the tax system affects companies organized as small businesses, compared with larger enterprises. I will discuss provisions of the current tax law that affect the relative incentive to organize economic activity within small or larger business enterprises and between different forms of enterprises and how selected tax reform proposals would affect these choices.

Small Business and the Current Tax System

Most of our economic activity occurs within large corporations, nonprofits, and public enterprises. But some rough calculations I have made suggest that the small-business sector accounts for about 25 percent of GDP¹. While the activities of small and large businesses are in many ways complementary—each group is both a customer and supplier to the other—the way in which businesses are organized matters for productivity. Large organizations have advantages of economies of scale, broader reach, and ability to diversify risks, while small businesses have advantages of greater flexibility and less need for bureaucratic controls. No one business form is best for all activities. Ideally, the tax system would be neutral among different forms of business organization so that market forces—rather than tax considerations—will drive firm behavior and allow the optimal forms to emerge.

A few provisions of the current federal income tax code explicitly favor smaller over larger businesses, but provisions that favor flow-through enterprises over taxable corporations have a much greater effect. These provisions do not explicitly discriminate among businesses by size. But they generally favor sectors with relatively large numbers of small businesses, which are more likely to be organized as flow-through enterprises than larger businesses. They influence both small and large businesses to organize themselves as flow-through enterprises and provide incentives for taxable corporations to contract out labor services to and lease capital from flow-through businesses instead of employing labor and capital directly. Finally, the technology of tax administration and compliance confers important advantages and disadvantages on small compared with larger businesses, apart from what the tax law explicitly requires.

¹ Eric Toder, “Does the Federal Income Tax Favor Small Business?” National Tax Association, Proceedings of the 100th Annual Conference, 2007. http://www.urban.org/UploadedPDF/411606_income_tax_favor.pdf.

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