The Small Business Conundrum

If I were ever to run for office, I’d change my name to Small Business. It’s a surefire way to soar in popularity. Everyone would be a champion, and I’d get credit for innovation, embodying the American spirit, keeping small towns alive and friendly, creating jobs and propping up the U.S. economy. I’d also get special tax breaks, government backed loans and relief from many regulations that affect other businesses. And I’d be hailed as the polar opposite of everything Americans hate -- big government, big oil and big banks.

But would I deserve all that adoration? That’s a question well worth exploring as politicians -- especially candidates facing the voters next month -- fall all over themselves to prove they are champions of small business. This debate over the role of small business affects a wide range of issues, but right now, it’s having a huge impact on the battle over President Obama’s plan to let the Bush administration tax cuts expire on top earners -- singles making more than $200,000 a year and couples over $250,000.

The first question is how you define small business, a question muddled by the fact that most definitions have an incredibly wide range. That’s why Republicans can justify claims that President Obama’s plan would be a huge, job-killing tax that would affect half of small business income while Democrats can justify claims that fewer than 3% of small businesses would be affected.

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Definitions can start with some measure of consensus. I think we all agree that the local independent grocer or hardware store owner or baker selling cupcakes out of his kitchen would clearly qualify. But the definition used by the government and many politicians includes much bigger companies. The Small Business Administration’s research on smalls, for example, includes any company with up to 500 employees. And the IRS counts as small business income anything that is reported on a Schedule C.

In fact, though, a lot of that income is generated by very large firms that are partnerships or S corporations, which pass through their profits to owners, partners and others, who then report the income on Schedule C. Filers include physicians, lawyers, lobbyists, consultants, architects and the like who make hundreds of thousands of dollars each year. They also include hedge fund managers, who make tens of millions. Economics professor Richard Thaler pointed out in a recent New York Times column that until Goldman Sachs went public, it, too, was an S corporation.

Also part of the small business income total is the money that salaried folks make in freelance or consulting fees on the side, the income that goes to a member of a business-owning family who has no role in managing that business and any money made by people with profitable hobbies. Not many of these people are actually responsible for creating jobs or for innovation.

It’s also wrong to imply that these and other high-income earners would get no tax break under Obama’s plan. The president only wants to raise the marginal tax rate -- the rate applied to incomes over the $250,000 limit. There would still be a tax cut on the first $250,000 in income no matter what the total.

All of this brings us back to the basic question: Should tax rates on top earners go up if it would mean an increase for even a small number of small businesses with high profits? Would it be a job killer?

Every manager is different, with a different mindset and different priorities, and it’s foolish to generalize. Certainly higher taxes may mean less spending by high incomers, but few economists believe it will lead to fewer jobs. As Leonard Burman, a professor at Syracuse University, told CQ recently, “If you can hire someone and you can make another dollar, that’s worth doing, whether you get to keep 60 cents of the dollar or 65 cents.”

But higher taxes could be a significant drag on business owners trying to save for investment. Those folks would clearly have a smaller share of profits to put aside for growth, and that’s a real issue, especially if credit is tight. Unfortunately, few people running for Congress are talking about that or seriously trying to parse this complex issue, presumably because it’s too hard to explain in a 20-second sound bite.