Trade and Tax Issues Relating to Small Business Job Creation

Chairman Baucus, Ranking Member Grassley, and Members of the Committee: Thank you for the opportunity to submit this statement to the Committee regarding tax issues pertaining to small businesses and job creation. This statement draws heavily on an article that we recently published on the taxation of big and small business.[1]

We laud the Committee's interest in job creation, but urge the Committee to broaden its focus beyond small businesses. Economic policy should focus on creating jobs at firms of all sizes.

Favoritism toward small business is gaining additional momentum in the debate over how to avoid the jobless recovery that we experienced in the previous two recessions. Policies directed toward small businesses are at the heart of President Obama's plan to revive the economy, as outlined in his State of the Union address and his fiscal 2011 budget. The president proposed a credit for business hiring that would be limited to $500,000 per firm (thereby preventing large firms from reaping its full benefit) and a program to increase lending to small businesses. As discussed in more detail below, the president has also proposed the elimination of capital gains tax on certain stock in small businesses and the extension of expanded Section 179 expensing. These policy changes, if enacted, would add to the long list of policies that favor small firms.

In this statement, we describe some of the current and proposed policies that favor small over big businesses and then critique the arguments that have been offered in support of such favoritism. We conclude by advocating that policy encourage job creation at firms of all sizes.

The Policy Tilt toward Small Business

Numerous tax and spending measures are rooted in the misperception that small businesses play a unique role in job creation in the U.S. economy:[2]

  • On the spending side, the Small Business Administration (SBA) offers contract preferences, loan guarantees worth nearly $28 billion, and other assistance to small firms.[3] The stimulus package passed last year provided $730 million in additional funding for the SBA's emergency lending activities, and the president's fiscal 2011 budget allocates almost a trillion dollars for the agency's yearly operations, a 21 percent increase over the agency's 2010 funding.[4]

  • Smaller firms have greater ability to avoid the corporate income tax because they can more easily organize as sole proprietorships, partnerships, or limited liability companies, which are not subject to corporate income tax. Even if a small firm organizes as a corporation, it can still choose subchapter S status and thereby avoid corporate income tax if it has one hundred or fewer stockholders and meets certain other conditions. In contrast, large, publicly traded firms have no choice but to pay corporate income tax. Their income is then subject to double taxation, with corporate tax imposed at the firm level and dividend and capital gains taxes imposed (at a preferential 15 percent rate) at the stockholder level.

  • Even among firms that are subject to the corporate income tax, smaller firms face lower tax rates. While large corporations pay a 35 percent rate on their taxable income, small corporations pay 15 percent on the first $50,000 of taxable income and 25 percent on the next $25,000. Also, corporations with gross receipts of less than $5 million are exempt from the corporate alternative minimum tax.

  • The net operating loss carryback relief offered by the 2009 stimulus legislation was initially limited to firms with gross receipts of less than $15 million. Although legislation enacted in November 2009 extended some relief to larger firms, small firms continue to enjoy more favorable treatment than large firms.

  • Tax discrimination against large firms has been particularly conspicuous in the oil industry. A tax break known as percentage depletion is available to independent oil producers, but not to integrated, generally larger, producers that refine as well as drill. Small oil producers also get more generous tax treatment for intangible drilling costs.

A few provisions deserve special mention because changes to them are now being considered:

  • Section 179 of the Internal Revenue Code gives small firms more generous tax treatment on their equipment and software investments. For 2008 and 2009, this provision, as expanded by the 2009 stimulus legislation, allows firms with less than $800,000 of such investments to deduct immediately the first $250,000 when they are made rather than depreciating the costs over time. For big firms, however, the amount that can be immediately deducted is reduced dollar-for-dollar as equipment and software investments rise above $800,000, until the provision completely phases out at $1.05 million. President Obama has proposed that these higher values be extended through 2010.

  • Investors are also allowed to exclude from taxable income 50 percent (75 percent in 2009 and 2010) of capital gains on stocks in businesses that have less than $50 million of assets, if the stock is originally issued and is held for at least five years. President Obama has proposed that the exclusion be increased to 100 percent.

The critical question is whether the preferences for small business, either in current law, or in the new proposals, are warranted. As discussed below, economic theory and evidence clearly call for neutral treatment of firms of all sizes.

Is Small Business Special?

Despite the extensive favoritism for small firms, there is no economic rationale for most of the preferential provisions. To begin, there should be no illusion that a preference for small business over big business is a way to provide tax relief to people with lower incomes. In fact, the bulk of small business income goes to high-income households; in 2006, households in the top two income tax brackets received 72 percent of all income from noncorporate firms and S corporations.[5] Indeed, an advantage of large firms is that their ownership shares can be publicly traded on stock exchanges, making it easier for ordinary workers and investors to buy shares, either directly or through pension funds and mutual funds.

The most common argument for preferential treatment of small business--its uniquely powerful role in job creation--does not stand up under scrutiny. To begin, the statement that small firms create the majority of jobs does not imply that they play a unique role in job creation. No matter how jobs are distributed across firm sizes, one can always find some threshold size such that firms smaller than that size account for a majority of jobs.

Careful statistical studies do not assign any special role to small firms. Instead, such studies have largely reaffirmed Gibrat's Law, formulated by Robert Gibrat in 1931, which holds that there is no relationship between a firm's employment size and its growth rate of employment.[6] As Federal Reserve Bank of Cleveland economists Ben R. Craig and James B. Thomson and University of North Carolina professor William E. Jackson III noted in 2004, "economic studies find little evidence to support" the claim that small businesses are an important source of employment growth.[7] In their authoritative book on job creation and destruction, Steven J. Davis of the University of Chicago and AEI, John C. Haltiwanger of the University of Maryland, and Scott Schuh of the Federal Reserve Bank of Boston dismiss what they call the "small business job-creation myth," concluding that "conventional wisdom about the job-creating prowess of small businesses rests on statistical fallacies and misleading interpretations of the data."[8]

Davis, Haltiwanger, and Schuh, along with other authors, emphasize the "regression fallacy" that arises from temporary changes in firm employment. Most of the studies computing job gains between two dates classify firms as big or small based on their size at the earlier date, a practice that inflates job gains at small firms.[9] When a firm that has temporarily become small due to a recent setback regains its former position, a job gain for a small firm is recorded; when a firm that has temporarily become large due to a recent expansion falls back to its prior position, a job loss at a large firm is recorded. Opposite results are obtained if the firms are classified as large or small based on their employment at the later date.[10]

It is also important to look at net, rather than gross, job gains. For any category of firms and time period, gross job creation is the sum of job gains at those firms that added jobs during the period. Conversely, gross job destruction is the sum of job losses at those firms that reduced jobs during the period. Net job creation is equal to gross job creation minus gross job destruction. As Davis, Haltiwanger, and Schuh--and others--document, smaller firms have proportionately higher rates of gross job creation than larger firms. Unfortunately, small firms' high gross job creation is offset by high gross job destruction. Davis, Haltiwanger, and Schuh conclude that "[i]n a nutshell, net job creation in the U.S. manufacturing sector exhibits no strong or simple relationship to employer size."[11]

Recent research by Giuseppe Moscarini of Yale University and Fabien Postel-Vinay of the University of Bristol finds that small firms tend to report stronger employment growth than large firms during periods of economic weakness but weaker employment growth during upturns, with little net difference across the overall business cycle.[12]

While there may be no strong pattern of differences in net job creation between large and small firms, one difference is well established: jobs at large firms tend to feature higher wages and other desirable attributes. In the words of Davis, Haltiwanger, and Schuh, "A large body of empirical research documents that, on average, larger employers offer better wages, fringe benefits, working conditions, opportunities for skill enhancement, and job security."[13]

Distorting the Economy

Even if small firms play no unique role in job creation, one might think that tax policies that favor small firms over big ones are harmless. Unfortunately, that is not true. Preferences for some firms over others interfere with the market's allocation of resources and disrupt the efficient workings of the economy.

Consider a simple example in which the profits of small firms are taxed at a 20 percent rate and those of large firms are taxed at a 50 percent rate. (These numbers are purely illustrative and do not correspond to actual tax rates.) Investors are willing to invest in any project that provides at least a 4 percent after-tax rate of return. Thus, they will invest in all small-firm projects that yield at least 5 percent before tax and all large-firm projects that yield at least 8 percent before tax.

The good news is that this tax system does not end up treating anyone unfairly. Although investors in large firms are taxed more heavily, they are compensated by a higher before-tax return. Since all investors clear 4 percent after tax, no one can complain about unfair treatment.

The bad news is that this tax system wastes resources and causes inefficient production, reducing the amount of output that can be produced from the total investment funds available. All large-firm projects with before-tax returns below 8 percent fail to go forward because they cannot provide a 4 percent return after paying the 50 percent tax. Yet, small-firm projects that yield as little as 5 percent go forward. Output would be higher if funds were reallocated away from small-firm projects that yield 5 or 6 percent to large-firm projects that yield 7 or 8 percent.

With neutral tax treatment, the market would produce an efficient allocation of resources. If both sectors were taxed at 33 percent, all projects yielding more than 6 percent before tax would go forward in both sectors, while all projects yielding less than 6 percent would not. There would then be no way to reallocate funds to achieve higher total output. Uneven tax treatment blocks this efficient outcome. Furthermore, neutral tax treatment would still be appropriate even if small firms really did create more jobs than large firms. If small firms have a competitive advantage in job creation, they will be able to exploit that advantage in a neutral tax environment.

In one respect, placing heavier taxes on large firms is worse than other types of uneven tax treatment because it imposes a built-in penalty on growth. For example, Section 179 puts a penalty on increasing equipment and software investment above $800,000 because each additional dollar invested reduces the amount that can be immediately deducted.

There is no reason for tax and spending policy to tilt the scales between big and small firms.[14] There is nothing inherently bad about being big.


Small business has played, and will continue to play, an important role in the American economy. But the role of big business is equally important. Public policy should protect firms of all sizes from unnecessary taxes and regulation. And, job creation efforts during the current recession should apply to firms of all sizes. We urge the Committee to heed the testimony offered by Chris Edwards at the hearing:

"Congress should focus on creating a simple, neutral, and pro-growth tax structure for all American businesses, large and small . . . A new job at a multinational computer chip maker is certainly as valuable as a new job at the corner restaurant, and probably more durable."[15]

In particular, we urge that incentives for the hiring of new workers not be capped per firm. There is no reason why the benefits of the incentive should be limited at big firms. Also, as Eric Toder of the Urban Institute noted in his testimony, limiting the credit in this manner means that large firms continue to receive a credit, but have no direct incentive to hire more workers.[16]

As policymakers continue to honor small business as an engine of economic growth, they should give equal recognition to big business, the other engine of economic growth.

Alan D. Viard is a resident scholar at AEI. Amy Roden is a Jacobs Associate and the program manager for economic policy studies at AEI.


  1. Alan D. Viard and Amy Roden, "Big Business: The Other Engine of Economic Growth," AEI Tax Policy Outlook, June 2009, available at
  2. For more complete discussions, see Jane G. Gravelle, "Federal Tax Treatment of Small Business: How Favorable? How Justified?" NTA Proceedings of the 100th Annual Conference (2007), available at (accessed June 10, 2009); Eric Toder, "Does the Federal Income Tax Favor Small Business?" NTA Proceedings of the 100th Annual Conference (2007), available at (accessed June 10, 2009); and Andrew B. Lyon, "Tax Reform and Small Business" (testimony, Committee on Small Business, U.S. House of Representatives, April 10, 2008), available at (accessed June 1, 2009).
  3. Ben R. Craig, William E. Jackson III, and James B. Thomson, "Are SBA Loan Guarantees Desirable?" Federal Reserve Bank of Cleveland Commentary, September 15, 2004, available at (accessed June 10, 2009); and Emily Maltby, "$700M for Small Business in Obama's Budget,", March 3, 2009.
  4. "Small Business Administration." The Budget for 2011 Fiscal Year available at
  5. U.S. Department of the Treasury, "Treasury Conference on Business Taxation and Global Competitiveness" (background paper, July 23, 2007), 15, available at (accessed June 11, 2009). See also Jane G. Gravelle, "Federal Tax Treatment of Small Business: How Favorable? How Justified?"; and Gene Steuerle, "When Is It Best to Tax the Wealthy? (Part 2 of 2)," Tax Notes, December 19, 2005, available at (accessed June 10, 2009).
  6. For further explanation and evidence of Gibrat's Law, also known as the Law of Proportional Effect, see John Sutton, "Gibrat's Legacy," Journal of Economic Literature 35, no. 1 (1997): 40-59.
  7. See Ben R. Craig, William E. Jackson III, and James B. Thomson, "Are SBA Loan Guarantees Desirable?"
  8. Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction (Cambridge, MA: MIT Press, 1996), 57, available through
  9. Véronique de Rugy, "Are Small Businesses the Engine of Growth?" (Working Paper 123, AEI, December 8, 2005), available at
  10. Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction, 66-70. For a vivid illustration of the regression fallacy, see Cordelia Okolie, "Why Class Size Methodology Matters in Analyses of Net and Gross Job Flows," Monthly Labor Review (July 2004): 10, available at (accessed June 10, 2009).
  11. Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction, 10-11, 60-62; and Véronique de Rugy, "Are Small Businesses the Engine of Growth?"
  12. Giuseppe Moscarini and Fabien Postel-Vinay, "Large Employers Are More Cyclically Sensitive" (Working Paper 14,740, National Bureau of Economic Research, Cambridge, MA, February 2009), available at (accessed June 10, 2009).
  13. Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction, 170-71.
  14. There is one legitimate reason for tax policy to distinguish between small and large firms. The cost of complying with tax and regulatory provisions is often proportionately greater for small firms than for large firms, which can put small firms at a competitive disadvantage and can justify offering them relief from some compliance burdens. But, this rationale has little relevance to the job-creation measures now under consideration.
  15. Statement of Chris Edwards before the Senate Committee on Finance "Tax Issues Related to Small Business Job Creation," February 23, 2010 ( p.1.
  16. Statement of Eric J. Toder before the Senate Committee on Finance, "Tax Issues Related to Small Business Job Creation," February 23, 2010 (, p. 5.
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