Small business plays a vital role in the nation’s economy. But as the April 15 tax filing deadline approaches, that familiar refrain often cited by politicians, government officials, and small business advocates, begs an important question: If small businesses play such an important role, why is the nation’s tax code slanted against them?
The House Small Business Committee held a hearing this week to examine that very question. As always, there were no simple answers. In an ideal world, of course, the government would promote a “simple, transparent business tax system with the lowest possible rates,” said Andrew B. Lyon, a lobbyist with PricewaterhouseCoopers LLP. The goal would be equal treatment of small and large firms, “so as to maximize economic output for a given level of business taxation,” he testified.
Indeed, most economists believe that when it comes to taxes, an equitable, level playing field is the best and most productive approach. But the current system falls short of that. In fact, the very presence of a tax system may in itself impose an inordinate compliance burden on small business relative to large business, according to a 2004 study by University of Michigan Business School and Economics Professor Joel Slemrod.
Today it costs about $135 billion for taxpayers of all stripes to comply with the 4,000-page tax code, according to the Slemrod study. Of that, $85 billion is paid by individual taxpayers, while businesses other than sole proprietorships pay $40 billion.
A separate study by the IRS examined nearly 7.2 million small businesses made up of partnerships, S-corporations, and C-corporations with assets less than $10 million in revenues. These businesses spent between 1.7 billion and 1.8 billion hours on tax compliance, and incurred out-of-pocket expenses of between $15 billion and $16 billion, according to the study.
“If the time spent on tax compliance is valued at $40 per hour (an annual salary of $83,200), the total compliance cost to small businesses is between $83 million and $90 billion, or an average burden of about $12,000 per small business. This estimate significantly exceeds Slemrod’s estimate of business compliance costs,” Lyon told the House Small Business Committee.
By those parameters, compliance costs actually exceed revenue for the smallest businesses (total receipts less than $10,000). For businesses with receipts between $100,000 and $500,000, compliance costs are about 5 percent of total receipts. “For low-margin businesses, these compliance costs can represent a significant percentage of net income and, for many businesses, can exceed net income. From these estimates, it is apparent that compliance costs represent a very significant implicit tax on small business income,” testified Lyon.
Now here’s where the playing field really begins to tilt. Businesses with less than 500 employees do, in fact, represent 99.7 percent of all firms, and account for half of all private employment and 45 percent of all private payrolls, according to the most recent figures available from the SBA’s Office of Advocacy. But those businesses aren’t paying the lion’s share of taxes. They only account for 31 percent of total tax receipts and 37 percent of business payrolls, according to IRS data.
In contrast, large corporations earning $50 million or more in annual revenue represent just 0.1 percent of all businesses. Yet they account for 69 percent of total tax receipts and 63 percent of business payrolls. In short, money talks. Large corporations have traditionally had tremendous influence in Washington when it comes to tax policy. The problem is the tax code is like a water balloon. Squeeze it in one place to benefit one special interest, and it bulges in a different place to the disadvantage of another.
The resulting patchwork of tax incentives, credits, set-asides, special deductions, accelerated depreciation rules, and withholding schedules can work for and against small businesses. Under the Alternative Minimum Tax (AMT), for example, businesses that operate as sole proprietors or pass through companies (LLCs, LLPs) can’t deduct state and local income taxes on business income, although corporations are allowed to do so. Corporations (including S-corporations) and certain partnerships can have capital income, which is taxed at the lower capital gains rates rate. But sole proprietorships can not.
It would take a book to catalog all of the distortions woven into today’s tax code. That’s why the best long-term solution is to simplify the current system. The expenses businesses spend navigating complex tax rules produce no economic benefit for society, Lyon noted. A simpler tax system would allow these business resources to be channeled into more productive activities that add to the future growth and increase the standard of living across the entire economy — not to mention, save a lot of small business owners from the pencil-snapping frustration of this time of year.