Does the Federal Income Tax Favor Small Business?

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Abstract

Small business is the source of our entrepreneurial genius, creativity, and productivity. Nonetheless, a substantial portion of our economic activity occurs within large corporations, non-profits and public enterprises. This paper discusses how the federal income tax treats firms of different sizes. It reviews specific provisions favoring small businesses and more general aspects of the federal income tax that may differentially affect firms of different sizes and also discusses how opportunities for tax avoidance and costs of complying with the tax law affect businesses of different size.

Introduction

As these quotes suggest, everyone loves small business. Small business is the source of our entrepreneurial genius, creativity, and productivity. Small business opens up opportunities for all Americans, especially women and minorities. Small business is the great engine of American prosperity and job creation. The vision of individual risk-takers pursuing their dreams, free of the security blanket and limitations that corporate and government employers impose, is deeply imbedded in our national self-image.

Nonetheless, a substantial portion of our economic activity occurs within large corporations, non-profits and public enterprises. Of the U.S. GDP of $12.5 trillion in 2005, $6.4 trillion of gross value added originated in the corporate sector (51 percent), $3.2 trillion in other businesses (26 percent), $1.4 trillion in the government sector (11 percent) and another 1.4 trillion in the household and non-profit sector (11 percent). If all corporations were large businesses and all non-corporate enterprises were small businesses, this would imply that small business accounts for about a quarter of GDP. Even though many corporations are small businesses and many non-corporate enterprises are large businesses, calculations from business tax return data suggest this estimate of the relative contribution of small business is roughly correct.

Research showing that small business is the principal engine of new job creation (Birch, 1979) has been challenged by others. Armington and Odle (1982) found that large businesses generate most new jobs, while Davis, Haltiwanger and Schuh (1993) also refute the finding that small businesses generate more jobs than large businesses.

The supposed benefits of small business are sometimes used to justify tax incentives and other government benefits that favor smaller over larger businesses. Economic theory suggests that tax incentives for small businesses would cause a change in the size distribution of business organizations, resulting in an increased share of economic activity within smaller as opposed to larger business organizations. This would occur both through a shift in the composition of firms within industries and through a shift in the composition of economic activity among industries toward those sectors in which natural economic forces (absence of economies of scale, higher than average costs of within-firm coordination) are relatively more favorable to smaller than to larger firms.

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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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