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The Myth About Small Businesses (CQ Politics)

CQ Politics

The Myth About Small Businesses
By Richard Rubin, CQ Staff

There’s one type of American business that tends to fail frequently, leaving customers and employees in the lurch. Such companies routinely underpay their taxes, forcing everyone else to bear more of the cost of government. They typically provide lower wages and skimpier benefits than their competitors, imposing a financial toll on their workers.

There’s another type of American business that is the darling of Congress. Lawmakers and presidents extol these companies as the engines of job creation and the lifeblood of the nation’s economy. Federal policies are shaped to benefit them, and they receive preferential tax treatment and exemptions from burdensome regulations.The two types of companies are one and the same: small businesses.Small businesses are so exalted in the public imagination that criticizing them seems like hitting mom in the face with an apple pie. The term is so ill-defined that it’s almost meaningless, and that vagueness allows opportunistic politicians and corporate interest groups to present their own preferred policies under the mantle of small business.

Nearly every piece of major economic legislation passed by the 111th Congress has been framed by advocates as a boon to small business and derided by opponents as a disaster for those same small businesses. The post-election debate about the extension of the tax cuts enacted in 2001 and 2003 will be no different.

For politicians interested in electoral success, lavishing praise on small business makes perfect sense. The constant congressional genuflection to “the little guy” appeals to Americans’ visions of themselves as loyal corner-store shoppers and budding entrepreneurs. And the very word “big” is a term of opprobrium, as in “Big Oil,” “Big Tobacco” or “Big Government.” The persistent support for small businesses has a downside, however. Those public beliefs, reinforced by rare bipartisan consensus, create a potent, one-sided myth about the importance and virtue of small business. In fact, what gets labeled as “small business” in political discourse often bears little resemblance to the mom-and-pop image in our minds.

“It winds up hurting us because sometimes we’ll be invoked on issues that may not be central to most companies,” said Todd McCracken, president of the National Small Business Association, the oldest of several organizations that advocate for such enterprises. “When we’re invoked all the time, sometimes I think some folks lose focus on what matters to small companies.”

Congress, eager to create jobs and accelerate economic growth, continues to shape economic policy around small business. But the logic of focusing on small-business job creation during an economic recovery relies on faulty premises about the sources of employment growth, leading directly to skewed policies that emphasize business size as opposed to economic vitality or neutrality.

“Obviously, small business is good. It’s a part of our national identity,” said Alan D. Viard, a resident scholar at the American Enterprise Institute. “It does hire people and produces output. But, of course, that’s what big business does as well.”

Small Is Beautiful
The constant refrain about helping small business taps into a powerful part of the American psyche. As a society, we mythologize small-town America, the kind of place where everyone knows the dry-cleaner and the owner of the hardware store. It’s a resonant image because it evokes the personal-contact economy that many Americans no longer experience, and because it enables us to think about ditching the cubicle and working for ourselves. 

We also mythologize inventors and innovators, the garage and dorm-room tinkerers who turn a half-baked idea into Apple or Facebook. Even though these companies are now huge, their small-business roots make that improbable piece of the American dream seem more attainable.

Along with the military, small business is one of the few institutions in America that retains a strong, positive public image. According to an August poll by NBC and The Wall Street Journal, 84 percent of Americans say they have at least some confidence in small business. Compare that with large corporations and Congress, which have corresponding scores of 54 percent and 44 percent, respectively.

Small businesses are unquestionably an important segment of the economy and of local communities. Using the broad definition that includes all companies with fewer than 500 employees, they employ about half of private sector workers. Some of the negatives associated with big businesses — from overseas customer service agents to mass layoffs — are absent in the day-to-day contact that Americans have with smaller companies.

“It’s personal. It creates jobs, and people feel that. And they see the jobs created and they associate with innovation,” said Drew Westen, an Emory University scholar of political psychology who has helped Democrats frame their policies. “Big businesses are associated with the same bureaucracy that government is associated with.”

Small-business owners are also the cornerstones of communities. Real estate developers and community bankers, whose own interests are tied up with their cities’ futures, tend to get involved in civic life through their jobs in a way that chain-store managers and plant foremen don’t. That clout extends into local government, local business groups and the campaign-contribution cycle that propels members into office.

This popularity back in congressional districts makes everyone eager to be on small businesses’ good side, leading to the array of loan programs, contracting benefits and tax breaks that they now enjoy. At least sometimes, however, “small business” gets used solely as a convenient slogan.

“Democrats and Republicans routinely use small business as a justification for what they’re trying to do,” said Lloyd Chapman, president of the American Small Business League, which focuses on making sure contracting policies meant to benefit small business are not benefiting large corporations instead. “But when you actually look at what they do to help small business, I would say it’s difficult to find legislation passed in the last decade that helps small businesses and only small businesses.”

A package of benefits for small businesses signed by President Obama last week, for example, does include a number of provisions that would directly help those companies, such as lower fees for Small Business Administration loans, elimination of capital gains taxes on certain investments in small companies and assistance for state small-business programs. The law also includes a controversial lending program to address complaints about small businesses’ access to credit.

But it doesn’t do much to boost economic demand, which a recent survey from the National Federation of Independent Business showed was the No. 1 concern for business owners. And one of its major tax provisions is an extension of bonus depreciation, which the small-business law makes available to all companies, regardless of size. The ability to write off half of new investments will cost the government $40 billion in fiscal 2011 largely by accelerating deductions that would occur later in the decade. The smallest businesses don’t benefit much from those depreciation changes; they can already write off 100 percent of investments, up to certain thresholds.

Even small-business advocacy groups split over the attention lavished upon the little guys. Less-known and less-powerful organizations say they sometimes get ignored. Kristie Arslan, the executive director of the National Association of the Self-Employed, welcomed several provisions in the new law, especially a temporary deduction from payroll taxes of health insurance expenses for the self-employed. That’s a provision her group had been seeking for nearly a decade.

But she also argues that other ideas — such as a standardized home-office deduction that would make life simpler for millions of sole proprietors — get ignored amid a focus on a sliver of companies that are defined as “small” but are really quite large and successful. Those bigger small businesses, Arslan says, have more time to lobby Congress and have factories and stores that make better photo opportunities than a self-employed software engineer at a home computer.

“When you are looking at the actual policy, you see that a lot of proposals are really benefitting a small slice of small businesses,” she says.

For all the adulation heaped on small businesses, they still tend to lack the lobbying clout enjoyed by larger companies. That is particularly true when the two wings of the business world split over an issue and the bigger guys can quickly and efficiently get their message to lawmakers, said Mickey Edwards, a former Republican congressman from Oklahoma who is now a lecturer at Princeton’s Woodrow Wilson School of Public and International Affairs. “If you have the U.S. Chamber and IBM and General Motors and you have these people that have very large lobbying activities and a lot of money, they can sometimes just swamp the other side if it comes down to big vs. small,” he said.

Big businesses trying to influence the economic policy debate also try to align themselves with the popularity of small businesses. Last month, for example, under the title “Mutual Benefits, Shared Growth: Small and Large Companies Working Together,” the Business Roundtable released a study from Dartmouth economist Matthew J. Slaughter showing the extensive supply-chain links among businesses of all sizes.

He said there’s not much evidence for the idea that small businesses are somehow better than large ones and notes that their fates are closely tied to each other. “In a big economy like the U.S. economy, there’s an awful lot of links between firms of a lot of sizes,” said Slaughter, who was a member of President George W. Bush’s Council of Economic Advisers.

Is Smaller Better?
A clearheaded look at small-business policy raises a simple, important and rarely asked question: Why should size matter?

The first and often trickiest issue is defining “small business.” For research purposes, the Small Business Administration sets the threshold at 500 employees, which means that all but about 18,000 of the 27.5 million companies in the United States are classified as small. A more complicated set of industry-by-industry measures determines which companies qualify as small for federal contracts and other government programs. During tax debates, politicians often describe any business income reported on individual returns as being from “small business,” whether it comes from sales made at the neighborhood market, book royalties earned by the president or profits received by a partner at a big law firm.

Those definitional questions complicate the economic debates about the impact of small companies, but the core of most of those arguments starts with the assertion that small businesses generate the most net new jobs. Politicians then take the next step and contend that if the government is interested in job growth, it should enact policies that encourage small businesses to create jobs.

That all sounds logical, but it’s based on several fallacies.

It is indeed true that most private sector job growth occurs at small businesses. According to the SBA, 65 percent of the net new jobs created between 1993 and 2009 were generated by companies with fewer than 500 employees. But that employment growth is not evenly distributed. The net numbers obscure the fact that every year, more than 500,000 small businesses shut their doors.

The job growth is concentrated among startups and a relatively small group of young companies expanding quickly. A study released this summer by economists at the University of Maryland and the Census Bureau, analyzing data that became available in the past few years, found that after controlling for age, small companies don’t create jobs any faster than big ones do. “It’s hard for me to tell a story where small business has some magical power except for the fact that it’s young,” said Charles Brown, an economics professor at the University of Michigan who has written about the differences between small and large businesses.

In their first few years, startups tend to grow rapidly or die. This “up or out” dynamic suggests that job growth is concentrated among a relatively small number of successful startups, and it cautions against policies based solely on business size.

Given that background, governments interested in job growth might prefer incentives for startups and assistance to help those companies grow quickly. But that line of thinking rests on a false premise, too. Just because small businesses — or, if rethought more narrowly, startups and young businesses — generate the most net new jobs does not necessarily mean that they would generate more jobs if given assistance from the government. Additionally, a government policy that promoted more business startups might simply encourage doomed startup ideas that could not get off the ground without government assistance because they were not viable. “I guess, for some people as an initial guess, directing money to the sector that has been generating jobs in the past is the more effective thing to do,” Brown says.

Furthermore, it’s not clear exactly how these fast-growing businesses generate jobs or where those jobs come from. New jobs in the economy must come from some innovation that creates a market or from serving an expanding population. If startups use lower wage and benefits costs to undercut larger competitors, that may promote economic efficiency, but it won’t necessarily create new jobs.

The temptation for government, then, would be to search for new markets and new ideas that would expand the economy as opposed to shifting wealth from one person to another. But finding and successfully and efficiently encouraging those startup ideas can be risky, and it leads directly to the picking of winners and losers that politicians often decry.

Besides the job-growth argument, advocates of small-business policies make a corollary case. They say small companies need help because bigger companies can take advantage of economies of scale in business competition and in coping with government regulations.

Current law addresses all these arguments. Smaller companies, for example, can have trouble taking advantage of export markets without the internal infrastructure needed to cope with multinational regulations, and the new small-business law includes assistance for small-business exports. Some small companies are already exempt from complying with requirements such as granting family and medical leave. Depending on how they are structured, small companies can have tax advantages, such as the ability to pay their owners in “founder’s stock” that can be taxed as capital gains when sold.

But regulations have a public purpose, and that purpose can be undermined when exceptions are made.

A recent example is the much-discussed provision in this year’s health insurance overhaul that makes businesses file 1099 information-reporting forms to the IRS for each vendor receiving more than $600 in a tax year. In addition to helping offset the costs of the law, it was written to address a significant problem of tax evasion and avoidance by businesses, particularly small, cash-based operations. An IRS report analyzing 2001 tax data found that the estimated $109 billion in under-reported business income accounted for more than half of the tax gap between individual income taxes owed and collected.

Now, business lobbies are arguing that the paperwork will be burdensome to small business, and lawmakers from both parties are trying to repeal or modify the new requirement.

Intuitively, a rule exempting companies with 25 or fewer employees would help. In reality, it would just demonstrate how size isn’t everything. A hedge fund with 24 employees — but with hundreds of millions of dollars in revenue and millions in annual profits — could easily pay an accounting firm to file the correct forms and comply with the law, while a struggling 30-employee manufacturer in a weak corner of the economy might have a much harder time managing the same regulatory burden.

Hard-and-fast rules on size exemptions also yield unintended consequences. A recent study of the effects of the 2002 accounting overhaul law found that some companies made otherwise economically irrational maneuvers — such as reducing investment and reporting lower earnings — to avoid crossing a $75 million market-value threshold that requires significant changes in accounting procedures.

More recently, Republicans have used a similar argument to criticize two aspects of the health care law designed to protect small businesses. A tax credit for purchasing health insurance is available only to companies with 25 or fewer employees, and penalties for not purchasing health insurance will apply only to companies with more than 50 employees. Those thresholds will hold back business growth, Republicans argue, because companies will have an incentive to keep their employment levels below those targets or even to lay people off to hit the marks.

As Republicans criticize the health care law, their advocacy of small business causes a similar problem in one of their own proposals: a 20 percent deduction for small-business income that is part of the House Republicans’ recently released “Pledge to America.” Their plan defines small business as companies with fewer than 500 employees.

To avoid the perverse incentive they see in the health care law, the Republicans’ plan would allow companies to continue receiving the deduction even if they exceeded that size. As introduced by Michigan’s Dave Camp, the top Republican on the Ways and Means Committee, the bill would apply only in 2010 and 2011, which means relatively few companies would be able to exploit that provision after growing beyond the threshold.
 
But the bill also draws arbitrary lines to limit the scope of the provision. It piggybacks on various tax-code definitions of small business that exclude hotels, restaurants, banks, law firms, golf courses and liquor stores, among others, from taking advantage of the proposed deduction.

“There’s no universally accepted metric of support-worthiness, for lack of a better term,” said Donald Bruce, associate professor of economics at the University of Tennessee. “How do I choose which businesses are worth public support or not?”

Taxing Problems
Perhaps the most frequent — and most confusing — discussion of small-business policy occurs when Congress talks about marginal income tax rates.

That debate will again move to the political forefront after the election, when Congress will return to consider whether to maintain the tax cuts Bush pushed into law in 2001 and 2003 or let them expire as scheduled at the end of this year. In an attempt to raise revenue and to draw clear distinctions between “the rich” and everyone else, Obama has narrowed the debate to focus on the top two tax brackets. He and most Democrats want to let the tax cuts expire on income over $200,000 for individuals and $250,000 for married couples.

So far, much of the loudest debate in Congress has focused on competing claims about small business that are both accurate and misleading. Eager to ward off Republican complaints that the tax rate increase would hurt small businesses who report their profits on their owners’ individual tax returns, Democrats note that just 3 percent of taxpayers with business income would be affected.

Republicans respond by noting that the group still reports nearly half of all business income that shows up on individual returns. Democrats volley that many of the businesses reporting their income through individual returns are not small at all, including big accounting firms and big pipeline operators. Republicans counter that regardless of the size of the company affected, a tax increase on business income is still a tax increase.

The back-and-forth ignores an important question: Why is so much business income reported on individual tax returns?

In part, the answer is that in the 1980s, Congress provided tax advantages for small companies that operate outside the traditional corporate form. Companies that are not publicly traded can choose to be corporations or “pass-through entities.” Corporations must pay the corporate income tax rate, which tops out at 35 percent, on their profits, and their owners must also pay taxes on dividends or capital gains. Pass-through entities, such as partnerships, S corporations and sole proprietorships, don’t have to pay a tax; only their owners do, via their individual tax returns.

By lowering individual tax rates from their pre-Reagan levels and by liberalizing the rules for forming pass-through entities, Congress effectively encouraged businesses to avoid the corporate tax system altogether. As a result, the share of business done by pass-through entities has, unsurprisingly, increased dramatically over the past three decades. In 1980, 80 percent of net business income was earned in traditional corporations; by 2007, that share had dropped to 53 percent.

That trend is uncommon in other countries. Here, the recent commingling of business and personal income makes it difficult for contemporary Congresses to set separate tax policies for businesses and individuals — and it leads directly to this year’s confusion. Higher marginal tax rates on “the rich” apply equally to basketball star LeBron James, a doctor with a big practice and the owner of a successful manufacturing company.

With that broad a group in the top two tax brackets, sorting out the impact of a tax increase on “small business” becomes a morass of competing claims that are hard to reconcile with the available data. (Taxes and jobs, p. 2288)

Either way, the public debate seems unlikely to change, because the marketplace of political ideas has already declared a winner. “Both sides of the aisle know that Americans have a gut-level positive attitude toward small business and a gut-level negative attitude toward big business,” Westen said. “And so you hear both sides talk about small business.”

FOR FURTHER READING: Tax cut extensions, p. 2292, CQ Weekly, p. 2228; small-business benefits (HR 5297 — PL 111-240), p. 2233; ‘Pledge to America,’ p. 2230; Westen and Democratic strategy, p. 1082; State of Taxation, p. 898, 2009 CQ Weekly, p. 828; health care overhaul (PL 111-148, PL 111-152), p. 748; first Bush tax cut (PL 107-16), 2001 Almanac, p. 18-3; second Bush tax cut (PL 108-27), 2003 Almanac, p. 17-3. accounting overhaul (PL 107-204) 2002 Almanac, page 11-3. The Camp bill is HR 6168.