Earlier this month, the Department of the Treasury released a report to redefine “small business.” As Bloomberg reports:
Using the proposed definition, 20 million small business owners reported $376 billion in net business income for 2007, according to a Treasury analysis of returns that year.
Under a second, narrower definition in which profit or loss from a business represented at least 25 percent of a filer’s income, researchers estimated there were 9.4 million small business owners with $335 billion in reported income for 2007.
The previous methodology counted 34.7 million filers reporting $662 billion in income in 2007. Under the new definitions, the share of small-business income subject to the top two tax rates dropped to 32 percent under the broad definition and to 29 percent under the narrower one. By comparison, under the previous methodology, 50 percent of small- business income was taxed at the top two rates.
So, in an effort to “better identify” small business owners, Treasury applies two new thresholds to the population of taxpayers reporting business income. First, it narrows the field to those owners of businesses that made less than $10 million. It then separates out those owners whose business income represents less than 25 percent of their taxable income.
As a result, Treasury reports that the small business population has shrunk by about half. Presumably, using different thresholds, they could have eliminated the small business community entirely.
Our experience with reports like these is you need to separate the politics from the policy. On the politics, this exercise is a transparent effort to reduce the size of the small business community and minimize the impact that raising tax rates would have on them. Because, as we all know, that’s what Treasury is planning to do — propose new, higher taxes on at least some if not all of the pass-thru community.
As such, it wholly misses the mark. We oppose raising tax rates on business activity because it means less investment and fewer jobs, not because it only affects some arbitrarily defined group of taxpayers. Is a job at a firm that makes more than $10 million less valuable to the economy than a job at a firm that makes less?
From a policy perspective, our reaction is mixed. On the one hand, Treasury apparently has developed a new database that allows it to connect business activity with the shareholders who ultimately pay the taxes. This is an important step in allowing us to understand the relationship between business and taxation in the pass-thru world, and it should be helpful moving forward.
Beyond that, there’s little here. To its credit, Treasury makes clear that their new definition is entirely subjective. They say, “We note that our revised methodology is but one reasonable approach that could be used to identify small businesses and their owners.”
“Subjective,” yes. But “reasonableb?” Why 25 percent? The Tax Policy Center engaged in the same “minimizing” effort back in 2004, but they used a 50 percent threshold. One threshold has no more relevance than the other. What difference does it make whether there are fifty investors owning one rental property each, or one investor owning fifty units? Their contribution to the economy is the same, but under the Treasury definition, only the latter investor would “count.”
Even on its own terms, Treasury’s definition is badly flawed. Think about a 25-employee S corporation where the owner’s income is derived entirely from his salary and business profits. In a good year, those profits might exceed the arbitrary 25 percent threshold set by Treasury. In a bad, year, they may not. So in a bad year, this significant employer is no longer considered to be a “real” small business by Treasury. How does that contribute to our understanding of anything?
For these reasons, S-Corp is going to continue to focus on the contribution of all S corporations and, more broadly, all pass-thru businesses to jobs and economic growth. As our recent Ernst & Young study revealed, most private sector jobs are at pass-thru firms, with one job out of four at an S corporation.
That’s where the jobs are, and that’s where policymakers should keep their focus.