Small Business Tax Benefits: Overview and Economic Rationales

Small Business Tax Benefits:
Overview and Economic Rationales
Updated March 3, 2008
Gary Guenther
Analyst in Public Finance
Government and Finance Division



Small Business Tax Benefits:
Overview and Economic Rationales
Summary
The federal tax burden on small firms and its implications for their performance
and rates of formation and growth is one of those policy issues that never seems to
vanish from Congress’s legislative agenda. Continuing congressional interest in the
issue has set the stage for the enactment of a string of legislative initiatives in the past
decade or so to reduce this burden. The 110th Congress, like many of its
predecessors, is considering various proposals to expand current small business tax
preferences, or create new ones.
This report describes the principal federal tax benefits for small firms and
examines the economic arguments for and against them. It will be updated when new
benefits are added to the federal tax code, or current ones are modified or repealed.
While the federal revenue cost of existing small business tax preferences is not
known, estimates of the revenue lost because of federal tax expenditures indicate that
this cost could exceed $11 billion in FY2007, according to the Treasury Department
and Joint Committee on Taxation. The following small business tax benefits have
the broadest reach outside agriculture: the taxation of small firms as passthrough
entities, the graduated rate structure for the corporate income tax, the expensing
allowance for equipment under Section 179 of the Internal Revenue Code, the
exemption of some small corporations from the corporate alternative minimum tax,
cash basis accounting, and the exclusion from taxation of capital gains on the sale or
disposition of certain small business stock.
These benefits raise numerous interesting and significant policy issues. For
many economists, a key issue is whether or not preferential tax treatment for small
firms can be justified on economic grounds. If such a justification cannot be found,
then proposals to further enhance small business tax preferences may distort the
allocation of economic resources among sectors.
Proponents of targeting tax relief at small firms say such relief is justified for
several reasons. First, they claim that small firms create singular opportunities for
social and economic advancement. Second, proponents point to evidence that rates
of small business formation are sensitive to tax rates. Third, small firms account for
significant shares of national income, jobs, and technological innovations. Fourth,
they can serve as powerful agents for economic renewal and structural change. And
last but not least, proponents maintain that small firms face constraints on their
ability to raise capital in debt and equity markets that do not apply to most large,
established firms.
Critics of small business tax preferences argue that it is difficult to justify them
on economic grounds. They say such preferences lessen the progressivity of the
federal income tax and raise the return on small business investment in ways that
undermine social welfare. In addition, critics contend that some small business tax
preferences are inappropriate or poorly designed, magnifying any efficiency losses
they might cause.



Contents
Firm Size: How Small Is Small? .....................................1
Main Federal Tax Benefits for Small Business...........................3
Taxation of Passthrough Entities..................................4
Graduated Corporate Income Tax Rates............................6
Expensing Allowance for Certain Depreciable Business Assets..........7
Exemption of Certain Small Corporations From the
Corporate Alternative Minimum Tax..........................8
Amortization of Business Start-Up Costs..........................10
Cash Basis Accounting........................................11
Tax Incentives for Private Equity Investment in Small firms...........12
Partial Exclusion of Capital Gains on Certain
Small Business Stock..................................12
Losses on Small Business Investment Company Stock Treated
as Ordinary Losses without Limitation....................14
Rollover of Gains into Specialized Small Business
Investment Companies................................15
Ordinary Income Treatment of Losses on Sales of
Small Business Stock..................................15
Uniform Capitalization of Inventory Costs.........................16
Simplified Dollar-Value LIFO Accounting Method for Small Firms.....17
Tax Credit for Pension Plan Start-Up Costs of Small Firms............17
Magnitude of Small Business Tax Benefits.........................18
Economic Role of Small Firms......................................19
Economic Arguments For and Against Small Business Tax Preferences......20
Chief Economic Arguments in Favor of the Preferences...............21
Special Economic Role of Small Firms........................21
Opportunities for the Social and Economic Advancement of
Immigrants, Women, and Members of Minority Groups......22
Imperfections in Capital Markets.............................23
Impact of Progressive Income Taxes..........................23
Chief Economic Arguments Against the Subsidies...................24
Equity Concerns..........................................24
Efficiency Concerns.......................................25
Other Concerns..........................................27
Conclusions .....................................................28
List of Tables
Table 1. Estimated User Cost of Capital Under-Expensing................19



Small Business Tax Benefits:
Overview and Economic Rationales
Some policy issues never seem to vanish from the congressional legislative
agenda. One such issue is the federal tax burden on small firms and its effect on their
performance and prospects for growth.
Many lawmakers view small firms as a whole as a vital and indispensable
source of job creation, economic opportunity, and technological innovation. Many
of these same individuals regard current federal taxation of small firms both as a
barrier to their formation and a drag on their growth, and as a policy instrument for
stimulating their rates of formation and growth. Such a dual perspective has
facilitated the enactment of a variety of small business tax benefits in recent decades.
In addition, the 110th Congress is considering a number of proposals to further reduce
the tax burden on small business by enhancing some current small business tax
benefits, creating new ones, or simplifying tax compliance for small firms.
Existing small business tax benefits and proposals to enhance or expand them
raise several policy issues. One is the substantial resources transferred to small firms
through such subsidies and the long-term economic effects of this transfer.
Statements made by some lawmakers suggest that they think the long-term economic
benefits of small business tax preferences outweigh their short-term revenue cost.
Another key policy issue concerns whether these preferences can be justified on
economic grounds. If such a rationale cannot be found, or if it appears tenuous at
best, then small business tax preferences may end up harming social welfare in the
long run.
This report explores these issues by examining the main small business tax
preferences and the economic arguments for and against them. It begins with a brief
description of current federal tax preferences for small firms, then reviews what is
known about the economic role of small firms, and concludes with a discussion of
the principal economic arguments for and against these subsidies.
Firm Size: How Small Is Small?
When considering the ways in which the federal tax code favors small firms and
what is known about the economic role of small firms, it is useful to understand how
small firms are defined for tax purposes.
Crafting such a definition in a manner that is widely accepted is a challenge, as
there is no uniform definition of a small firm in the many federal laws and
regulations offering assistance to small business. Instead, several criteria are used to



identify the firms that qualify for the benefits. It is not clear from the language of
these laws and regulations why such variation exists.
The absence of a uniform definition of a small firm may have its roots in the
Small Business Act (P.L. 85-536, as amended), which defines a small firm as “one
that is independently owned and operated and which is not dominant in its field of
operation.1“ The act goes on to specify that the definition of a small firm may vary
from industry to industry to reflect important structural differences among those
industries.2 Under the act, the Small Business Administration (SBA) has the
authority to establish (and alter, if necessary) the size standards and limits for
determining eligibility for federal programs to assist small business, many of which
are administered by the SBA. All federal agencies administering programs to set
aside a certain proportion of procurement contracts for small firms are required to use
SBA size standards and limits. But for other small business programs, federal
agencies have the choice of using SBA size standards and limits or establishing their
own.
In general, three criteria are used to identify the firms eligible for federal small
business programs. Each specifies the maximum size a firm (including affiliates) can
attain and still participate in the programs to which the criterion applies.
For the most part, the SBA uses two criteria to determine eligibility for the
programs it administers: (1) number of employees and (2) average annual receipts
in the previous three years. Application of these criteria varies by industry. For
example, the sole criterion for most manufacturing and mining firms is employment
size, and the upper limit is 500 employees; by contrast, for most retail and service
firms, the sole criterion is average annual receipts, and the upper limit is $6 million.
SBA’s current size limits for small firms range from $0.75 million to $28.5 million
for average annual receipts, and from 100 to 1,500 for number of employees.3 The
SBA Administrator has the authority to modify size standards for particular
industries. Before a proposed change can take effect, SBA’s Office of Size Standards
(OSS) must undertake economic studies of the affected industries — focusing on the
degree of competition, average firm size, start-up costs, barriers to entry, and the
distribution of sales and employment by firm size — and use the results to make
recommendations to SBA’s Size Policy Board. If the board agrees with the
recommendations, then it normally advises the Administrator to approve the
proposed change.
A third criterion used by federal agencies is asset size. Under this standard,
eligible firms would own assets up to a certain threshold, such as $50 million.
Among federal programs granting special benefits to small business, use of this
criterion is more limited than the number of employees or average annual receipts.


1 15 U.S.C. § 632(a)(1)
2 See [http://app1.sba.gov/faqs/].
3 Ibid.

How does the federal tax code define a small firm? Again, there is no uniform
definition. Instead, a variety of criteria are used to determine eligibility for current
small business tax preferences, and there is no obvious reason why the size limit
varies from one preference to the next.4 Some preferences rely on asset size, receipt
size, or employment size to select eligible firms. Others confer benefits on small
firms not through a specified size standard but through the design of the preference
itself. A case in point is the small business expensing allowance under Section 179
of the Internal Revenue Code (IRC): although allowance is not limited to firms of
a particular size, its design effectively confines its benefits to relatively small firms.
The lack of a uniform definition of a small firm in the federal tax code has its
advantages and disadvantages. On the one hand, it can lead to a firm being eligible
for some small business tax preferences but not for others. On the other hand, the
absence of a uniform definition gives lawmakers flexibility in crafting tax benefits
for small firms. Regardless of the practical consequences of the lack of a uniform
definition, it makes firm size a flexible concept that lawmakers can reshape, almost
without limit, to suit their legislative aims.
Main Federal Tax Benefits for Small Business
In general, all business income is subject to federal taxation. But not all
business income is treated equally under the federal tax code. Its tax treatment can
differ in several ways.
The taxation of business income depends on whether or not a firm is organized
for tax purposes as a corporation. Corporate net income is taxed twice (at the firm
level and then at the shareholder level), whereas the net income of passthrough
entities such as S corporations, sole proprietorships, limited liability companies, or
partnerships is taxed once (at the shareholder level).
In addition, the taxation of business income depends on whether or not a
corporation or the owners of passthrough entities pay the alternative minimum tax
(AMT). Corporations or business owners paying the AMT may be taxed at lower
marginal rates than their counterparts paying the regular corporate income tax.
The tax burden on business income also depends on how investments are
financed. For example, the returns to corporate investments financed solely by debt
are subject to lower marginal effective tax rates than the returns to investments
financed solely by equity, because corporations may deduct interest payments from
taxable income but not dividend payments.
Firm size is another factor affecting the tax treatment of business income.
Various provisions of the federal tax code offer benefits to smaller firms that are not
available or of lesser value to larger firms. The code makes no explicit or formal


4 According to one source, the Internal Revenue Code contains at least 24 different
definitions of a small business. See Douglas K Barney, Chris Bjornson, and Steve Wells,
“Just How Small Is Your Business?,” National Public Accountant, Aug. 2003, pp. 4-6.

distinction between the taxation of small and large firms in that it does not have
separate sections for small and large firms. Rather, the code contains numerous
provisions scattered throughout its many chapters that confer preferential treatment
on relatively small firms but not on relatively large firms. Most of these provisions
come in the form of deductions, exclusions and exemptions, credits, deferrals, and
preferential tax rates. In general, tax preferences such as these lower the cost of
capital for new investment by eligible firms relative to non-eligible firms. Certain
other provisions benefit small firms by reducing the cost and or burden of complying
with tax laws, or by making tax relief contingent on providing certain fringe benefits
to employees.
The federal small business tax subsidies with the broadest reach outside
agriculture are described below. Excluded from the list are subsidies targeted at
small firms in specific industries, such as life insurance, banking, and energy
production or distribution. It is not known what the total revenue cost is for the
subsidies discussed below. Nevertheless, recent estimates by the Joint Committee
on Taxation (JCT) and the Treasury Department indicate that they reduced federal
revenue by over an estimated $11 billion in FY2007.5
Taxation of Passthrough Entities
Business enterprises operate in a variety of legal organizational forms. The
business laws of each state determine the range of available choices. For federal tax
purposes, five such forms are widely used: subchapter C corporations, subchapter
S corporations, sole proprietorships, partnerships, and limited liability companies
(LLCs).
A firm’s organizational form has important implications for the taxation of its
earnings. The earnings of C corporations are taxed twice: once at the corporate level
and again at the individual level when the earnings are distributed to shareholders or
owners as dividends or realized capital gains. By contrast, the earnings of all other
business entities are taxed only once: at the individual level of their owners or
shareholders. As a result, these entities are often referred to as passthrough entities:
their earnings are not taxed at the entity level but pass through to the owners.6 The
entities’ profits, losses, and items of income, deduction, exclusion, deferral, and
credit are attributed to the owners according to their shares of ownership, regardless


5 In FY2007, the estimated combined revenue loss for seven of the most important small
business tax preferences is $11.445 billion. It pertains to the following seven small business
tax preferences: (1) expensing of depreciable business property; (2) reduced rates on the
first $10 million of corporate taxable income; (3) cash accounting outside agriculture; (4)
the partial exclusion of capital gains on the sale of certain small business stock; (5) the
amortization of business start-up costs; (6) the tax credit for new retirement plan expenses
of small firms; and (7) the ordinary income treatment of losses on the sale of small business
corporation stock. See U.S. Congress, Joint Committee on Taxation, Estimates of Federal
Tax Expenditures for Fiscal Years 2006-2010 (Washington: GPO, 2006), table 1; and
Office of Management and Budget, Analytical Perspectives, Budget of the United States
Government, Fiscal Year 2008 (Washington: U.S. Govt. Print. Off., 2007), table 19-1.
6 For more details on the taxation of non-corporate businesses, see CRS Report RL31538,
Passthrough Entities Not Taxed As Corporations, by Jack H. Taylor.

of whether the profits have been distributed. Most businesses operate as sole
proprietorships: in 2004, they accounted for 69% of federal business tax returns.
Next in order of importance were S corporations (12% of business tax returns),
followed by partnerships (8% of returns), C corporations (7% of returns), and LLCs
(4% of returns).7
There is no legal requirement that C corporations be relatively large in income,
asset or employment size, and that passthrough firms be relatively small. Yet such
a distinction holds in reality. In 2004, for example, the average C corporation’s asset
size was over six times greater than that of the average partnership and over 41 times
greater than that of the average S corporation.8
Whether a business owner would be better off operating as a C corporation or
as a passthrough entity is often a complicated decision involving a host of tax and
non-tax considerations. Key non-tax considerations include the legal liability of
shareholders, access to capital markets, and degree of shareholder control of
management. Foremost among the tax considerations are the relative tax rates for
corporate income, individual ordinary income, and long-term capital gains; the
investment horizon of investors; the holding period for corporate stock; and the rate
at which corporate profits are paid out as dividends.
Setting aside non-tax considerations for the moment, one can see that the current
mix of individual and corporate tax rates favors passthrough entities by a small
margin for investors in the highest income tax bracket. Such a group offers an
appropriate focus for this analysis because many small business owners are subject
to the highest marginal income tax rate. A few simple calculations prove this point.
In 2007, the top personal tax rate is 35%; most corporate profits are taxed at 35%;
and the top tax rate on long-term capital gains is 15%.9 Assuming an investment
horizon of one year — after which the firm’s assets are liquidated — tax
considerations alone would dictate that high-income investors would be better off
owning a business enterprise that is operated as a partnership rather than a
corporation. Under such a scenario, after-tax returns to a partnership would be $.65
for every dollar invested, whereas they would be $.55 for every dollar invested by a
corporation.10 Extending the investment horizon to five years does not alter the


7 Internal Revenue Service, Statistics of Income Bulletin: Spring 2007 (Washington: 2007),
pp. 256-260.
8 In 2004, the average asset size for partnerships returns was $4.6 billion; for S corporation
returns, $696 million; and for C corporation returns, $28.8 billion. See Internal Revenue
Service, Statistics of Income Bulletin: Fall 2006 (Washington: 2004), pp. 107 and
[http://irs.ustreas.gov/taxstats/index].
9 Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-
27), in 2003, the top individual income tax rate is 35% and is scheduled to remain at that
level through 2010, and the maximum rate on long-term capital gains is 15% for assets sold
after May 6, 2003 and before January 1, 2009.
10 These tax rates are derived from the following formula: (1-tp) is less than or equal to (1-
tc) x (1- tcg), where tp is the highest personal tax rate, tc is the highest corporate tax rate,
and tcg is the maximum tax rate on long-term capital gains. See Myron S. Scholes, et. al.,
(continued...)

outcome. Assuming that all after-tax income earned during that period is reinvested
in the business, the firm’s assets are liquidated after five years, and individuals in the
top tax bracket can earn a pre-tax rate of return of 20% whether the business is
operated as a partnership or a corporation, partnerships would earn a higher after-tax
rate of return than corporations: 13.0% versus 11.3%.11
Nonetheless, it would be incorrect to view the taxation of passthrough entities
as a small business tax benefit. The reason is that a firm’s size has no bearing on its
eligibility to operate as a passthrough entity. Firms that are relatively large in
employment, revenue, or asset size are organized as S corporations or partnerships,
while firms that are relatively small in those measures operate as C corporations. In
2003, 16% of S corporations and 7% of partnerships filing federal income tax returns
reported business receipts of $1 billion or more, while 22% of C corporations filing
federal income tax returns reported business receipts of less than $25 million.12
Any tax advantage presently held by small passthrough entities may prove
ephemeral, as it has in the recent past. For instance, their present advantage would
shift to corporations if legislation were enacted that sharply reduces the top corporate
and long-term capital gains tax rates relative to the maximum individual income tax
rate.
Graduated Corporate Income Tax Rates
Corporations with less than $10 million in taxable income are subject to a set
of graduated federal income tax rates. The rate is 15% on the first $50,000 of
income, 25% on the next $25,000, and 34% on selected amounts up to $10 million.
Corporations with taxable incomes ranging from above $10 million to $15 million
pay a marginal rate of 35%. What is more, in two income ranges, corporations face
marginal tax rates greater than 35%. A corporation with taxable income between
$100,000 and $335,000 pays a marginal rate of 39%, which is five percentage points
greater than the marginal rate on taxable incomes just above and below that range.
And a corporation with taxable income of more than $15 million up to $18.3 million
pays a marginal rate of 38%. These higher rates are intended to offset the tax savings
firms realized when their tax rates were less than 35%. All corporate taxable income
above $18.3 million is taxed at a rate of 35%. As a result, the tax savings from the


10 (...continued)
Taxes and Business Strategy: A Planning Approach, 2nd edition (Upper Saddle River, NJ:
Prentice-Hall, Inc., 2001), p. 67.
11 The after-tax rate of return for a partnership is derived from the following formula: $1[1
+ R x (1- tp)]n, where R is the expected pre-tax rate of return, tp is the highest personal tax
rate, and n is the investment horizon. And the after-tax rate of return for a corporation isn
derived from the following formula: $1[1 + R x (1- tc)] (1- tcg) + (tcg x $1), where R and
n are the same as the previous formula, tc is the highest corporate tax rate, and tcg is the
maximum tax rate on long-term capital gains. See Scholes, Taxes and Business Strategy.
pp. 66-67.
12 Internal Revenue Service, Statistics of Income Bulletin: Spring 2006 (Washington: 2006),
pp. 144 and 324.

graduated rates of 15% to 34% are limited to corporations with taxable incomes
under $335,000.
This graduated rate structure mainly benefits corporations that are relatively
small in employment or asset size, because their taxable incomes are likely to stay
below the $335,000 threshold. It also gives owners of closely held small firms an
added incentive to incorporate in order to shield any profits from higher individual
tax rates. But not all small corporations are allowed to take advantage of the reduced
rates. Specifically, the taxable income of corporations providing services in the
fields of health care, law, engineering, architecture, accounting, actuarial science, the
performing arts, and consulting is taxed at a fixed rate of 35%, regardless of the
amount.
The graduated rate structure is not without drawbacks. Specifically, it gives
smaller corporations a disincentive to grow to the extent that their incomes are taxed
at rates above 34%. In this sense, the higher rates serve as a tax on growth.
The revenue loss arising from the reduced rates on the first $10 million of
corporate taxable income came to an estimated $4.3 billion in FY2007.13
Expensing Allowance for Certain
Depreciable Business Assets
Expensing is the most accelerated form of depreciation for tax purposes. It
entails treating the cost of a depreciable asset such as a machine or building as an
ordinary and necessary expense rather than as a capital expenditure. Ordinary and
necessary costs are deducted in the year in which they are incurred, whereas capital
costs normally are recovered over longer periods by applying the depreciation
methods and schedules allowed in the federal tax code.
Under Section 179 of the Internal Revenue Code (IRC), firms may expense (or
deduct) up to $250,000 of the cost of qualified business property — mainly
machinery and equipment and computer software — placed into service in 2008 and
write off the remaining basis (if any) using a temporary 50% partial expensing
allowance and current cost recovery rules.14 The allowance drops back to $125,000
in 2009 and 2010 and is indexed for inflation in those years. Starting in 2011 (and
each year thereafter), the maximum allowance is scheduled to drop to $25,000.
Owing to a rule known as the dollar limitation, not all firms are able to take
advantage of the expensing allowance. Under this limitation, the allowance is
reduced by the amount by which the total cost of qualified property placed in service
during a year exceeds a phase-out threshold. In 2008, this threshold is set at


13 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2006-2010 (Washington: GPO, 2006), p. 35.
14 For more details on the design of the expensing allowance and its economic effects, see
CRS Report RL31852, Small Business Expensing Allowance: Current Status, Legislative
Proposals, and Economic Effects, by Gary Guenther. The limitation is higher in the case
of property used in certain economically distressed areas.

$800,000. It drops back to $500,000 in 2009 and 2010 and is indexed for inflation
in those years. Beginning in 2011 (and each year thereafter), the threshold is
scheduled to drop to $200,000. As a result, none of a firm’s spending on qualified
property placed into service in 2008 may be expensed once its total spending on such
property exceeds $1,050,000: $250,000 expending allowance plus $800,000 phase-
out threshold.
The allowance serves as a robust tax subsidy for small business investment. It
mainly benefits firms that are relatively small in revenue, asset, or employment size
because of the phase-out threshold. In addition, the allowance stimulates investment
by firms that can take advantage of it by deferring taxes on part or all of the first-year
returns to investment in qualified assets. This deferral yields a zero marginal
effective tax rate on the returns to this investment through the standard economic
model for the determination of the user cost of capital.15
In FY2007, the allowance produced an estimated revenue loss of $3.2 billion.16
The revenue effects of the expensing allowance in a particular year depend on the
level of business investment in that year. In periods of rising business investment,
the allowance typically produces a net revenue loss. But when business investment
falls following a period of sustained expansion, the allowance can actually yield a net
revenue gain. This shift from loss to gain reflects the timing of depreciation
deductions under expensing. Some firms write off the entire cost of an asset in its
first year of use by claiming the Section 179 expensing allowance, leaving no
depreciation deductions to offset future income earned by the asset.
Exemption of Certain Small Corporations From
the Corporate Alternative Minimum Tax
Under current federal tax law, many corporations must compute their income
tax liability under both the regular tax and the alternative minimum tax (AMT) and
pay whichever is greater. Each tax has its own rates, allowable deductions, and rules
for the measurement of taxable income.
In general, the AMT applies a lower marginal rate to a broader tax base. It
expands the corporate tax base by including a number of tax preferences under the
regular corporate income tax in the computation of taxable income under the AMT.
In addition, most tax credits allowed under the regular corporate income tax cannot
be used to reduce AMT liability. The current AMT originated with the Tax Reform
Act of 1986 and is mainly intended to insure that all profitable corporations pay at
least some federal income tax.
As a result of the Taxpayer Relief Act of 1997 (P.L. 105-34), certain small
corporations have been exempt from the AMT since 1998. Eligibility is determined
by a corporation’s average annual gross receipts in the previous three tax years. All
corporations formed after 1998 are exempt from the AMT in their first tax year,


15 See Jane G. Gravelle, “Effects of the 1981 Depreciation Revisions on the Taxation of
Income From Business Capital,” National Tax Journal, vol. 35, no. 1, March 1982, pp. 2-6.
16 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years

2006-2010, p. 34.



regardless of the size of their gross receipts. They remain exempt as long as their
average annual gross receipts do not exceed $5 million in their first three tax years,
and as long as their average annual gross receipts do not exceed $7.5 million in each
succeeding three-year period (e.g., 1999-2001, 2000-2002, etc.). If a corporation
loses its eligibility, it becomes subject to the AMT in the first tax year when it no
longer qualifies for the exemption and in every tax year thereafter, irrespective of the
size of its gross receipts.
There is some evidence that this exemption may give some eligible small
corporations a slight competitive advantage over comparable firms paying the AMT.
A 1997 study found that firms that invested heavily in machinery and equipment and
intangible assets like research and development (R&D), financed the bulk of their
investments through debt, and paid the AMT for five or more successive years had
a higher cost of capital than comparable firms that paid the regular income tax only
in the same period.17 In addition, the exemption gives owners of small firms an
incentive to incorporate, since the taxable income of passthrough entities is subject
to the individual AMT as well as the regular income tax.
A 2000 report by the Treasury Department’s Inspector General for Tax
Administration (TIGTA) suggested that the implementation of the exemption from
the AMT for small firms ran into some unexpected problems during the first year or
two of the exemption. According to the report, more than 2,300 small corporations
paid the AMT in 1998, though an examination of their federal income tax returns
indicated they qualified for the exemption. Their overpayments of the tax may have
totaled more than $25 million.18 The report attributed the erroneous payments to the
many complex changes in the corporate AMT made by the Taxpayer Relief Act of
1997 and the “short time” available to taxpayers and tax professionals to comprehend
the changes and apply them in filing 1998 tax returns. It recommended that the IRS
take a variety of steps to increase taxpayer awareness of the exemption, explain how
it is intended to work, and identify and contact taxpayers who erroneously paid the
AMT. In a recent follow-up report, TIGTA found that the IRS had taken many of
these steps, but that it still had failed to notify the more than 3,600 taxpayers who
may have mistakenly paid the AMT and fallen short of the agency’s commitment to
“inform and educate tax practitioners on what they need to do on their clients’
behalf.”19
It is not known whether there is a net revenue gain or loss from exempting small
corporations from the AMT. Exempt firms do not compute their AMT liability, but
they could end up paying the regular corporate income tax.


17 Andrew B. Lyon, Cracking the Code: Making Sense of the Corporate Alternative
Minimum Tax (Washington: Brookings Institution Press, 1997), pp. 77-97.
18 Treasury Department, Inspector General for Tax Administration, More Small Corporate
Taxpayers Can Benefit from the Alternative Minimum Tax Exemption Provision, no. 2001-

30-019 (Washington: Nov. 2000), p. 4.


19 Treasury Department, Inspector General for Tax Administration, Significant Actions were
Taken to Address Small Corporations Erroneously Paying the Alternative Minimum Tax,
but Additional Actions Are Still Needed, no. 2003-30-114 (Washington: May 2003), pp. 4-5.

Amortization of Business Start-Up Costs
One of the principles underlying the federal income tax is that taxable income
should exclude all costs incurred in earning it. This implies that all ordinary and
necessary costs incurred in conducting a trade or business should be deducted from
a firm’s taxable income. The principle also implies that ordinary and necessary costs
paid or incurred in connection with starting or organizing a business should not be
deducted from current income. Rather, because these expenses can be viewed as an
attempt to create an asset with a useful life extending beyond one tax year, it can be
argued that they should be capitalized, added to the taxpayer’s basis in the business,
and recovered when the business is sold or ceases to exist.
Under IRC Section 195, however, business taxpayers who incurred or paid
business start-up and organizational costs and then entered the trade or business on
or before October 22, 2004 may amortize (or deduct in equal annual amounts) those
expenditures over not less than five years, beginning in the month when the new
trade or business commenced. But under a provision of the American Jobs Creation
Act of 2004 (P.L. 108-357), business taxpayers who incur or pay business start-up
and organizational costs after October 22, 2004 may be able to deduct up to $5,000
of those costs in the year when the new trade or business begins. This maximum
deduction is reduced (but not below zero) by the amount by which eligible
expenditures exceed $50,000. Any expenditures that cannot be deducted may be
amortized over a period of 180 months, beginning in the month when the new trade
or business commences. In order to claim either allowance, a taxpayer must have an
equity interest in the new trade or business and actively participate in its
management.
To qualify for amortization or the deduction, the start-up and organizational
costs must meet two criteria. First, they must be paid or incurred as part of an
investigation into creating or acquiring an active trade or business, as part of starting
a new trade or business, or as part of any activity done to produce income or profit
before starting a trade or business with the intention of making such activity into an
active trade or business. Second, the costs must be the similar in kind to costs that
would be considered deductible if they were paid or incurred in connection with the
expansion of an existing active trade or business in the same industry entered by the
taxpayer.
Business taxpayers who choose not to claim the deduction must capitalize all
start-up expenses.
The option to deduct as much as $5,000 in business start-up and organizational
costs clearly benefits fledgling firms with relatively small such costs. It permits the
owners of such firms to deduct expenses that otherwise could not be recovered until
they sell their interest in the business. In effect, the option accelerates the recovery
of certain essential up-front costs for these firms, and this acceleration can aid their
formation and growth by reducing the cost of capital and increasing cash flow at a
time when the firms’ access to capital may be severely restricted.



According to the Joint Tax Committee, the amortization or deduction of
qualified business start-up and organizational costs led to an estimated revenue loss
of $0.7 billion in FY2007.20
Cash Basis Accounting
Under IRC Section 446, firms must compute their taxable income according to
the same method of accounting they regularly use in keeping their books. Two
methods of financial accounting are widely used in the private sector: cash-basis and
accrual-basis. Under cash-basis accounting, which is the preferred method for self-
employed individuals, income generally is recorded when it is received in the form
of cash or its equivalent, and expenses generally are recorded when they are paid,
regardless of when the income is actually earned or the expenses are actually
incurred. By contrast, under accrual-basis accounting, income and expenses
generally are recorded when the transactions giving rise to them are completed or
nearly completed, regardless of when cash or its equivalent is received or paid. More
specifically, a firm using accrual-basis accounting records income when its right to
receive it is established, and expenses when the amounts are fixed and its liability for
the expenses is established. Each accounting method has its advantages: in general,
cash-basis accounting is much simpler to administer, but accrual-basis accounting
often yields a more accurate measure of a firm’s economic income because it
matches income with expenses with greater precision and rigor. An important
requirement in selecting an accounting method for tax purposes is that it clearly
reflect a business taxpayer’s income.
Current federal tax law requires firms that maintain inventories to use the
accrual method in computing taxable income. The following entities generally must
also use the accrual method of accounting for tax purposes: C corporations,
partnerships with C corporations as partners, trusts that earn unrelated business
income, and authorized tax shelters.
Nonetheless, the cash method may be used by these entities provided they are
not a tax shelter and fall into one or more of the following categories: (1) the entity
is engaged in farm or tree raising, (2) the entity is a qualified personal service
corporation, or (3) the entity is a firm (including C corporations) with $5 million or
less in average annual gross receipts during the previous three tax years. Moreover,
the IRS has ruled that the cash method of accounting may be used by most sole
proprietorships, S corporations, and partnerships with average annual gross receipts
of $1 million or less in the three previous tax years (IRS Rev. Proc. 2001-10), and by
firms with average annual gross receipts of $10 million or less whose main business
is providing services or fabricating products according to customer designs or
specifications (IRS Rev. Proc. 2002-28).
As these rules suggest, many of the firms permitted to use the cash method for
tax purposes are likely to be small in receipt, asset, or employment size. Cash-basis
accounting can confer the same tax benefit on small firms as the expensing allowance


20 Joint Tax Committee, Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010,
p. 35.

under IRC Section 179: the deferral of income tax payments. In principle, a firm
earns income when the legal right to be paid comes into existence. Under the cash
method of accounting, however, a firm may delay the recognition of income until
cash payments are received, thereby postponing the payment of tax on that income.
Although many small firms may be eligible to use cash-basis accounting for tax
purposes, it may not always be practical or advisable for them to do so. The reason
lies in the requirements of the income statements and balance sheets used in external
financial reports.21 Cash-basis accounting can distort a firm’s financial position in
at least two ways. First, it records only transactions involving cash or its equivalent,
thereby excluding transactions involving exchanges of assets or liabilities. Second,
the determination of net income under cash-basis accounting can be manipulated by
recording revenues or expenses long before or after goods and services are produced
or sold. Thus, small firms with a strong need to produce reliable and accurate
external financial reports may be better off eschewing cash-basis accounting
altogether.
The Joint Committee on Taxation estimates that the use of cash accounting
outside agriculture resulted in a revenue loss of $0.8 billion in FY2007.22
Tax Incentives for Private Equity Investment in Small firms
The federal tax code also contains several provisions intended to encourage the
investment of private equity capital into some start-up small firms that might
otherwise find it difficult raising the funds needed to finance current operations or
expansions. These provisions, which are described below, do so largely by
increasing the potential after-tax returns or reducing the potential after-tax losses on
equity investment in such firms. The same tax benefits are not available to investors
who acquire equity holdings in larger established firms.
Partial Exclusion of Capital Gains on Certain Small Business Stock.
Two important considerations in determining an individual’s income tax liability are
the recognition of income as ordinary or capital and the distinction between long-
term and short-term capital gains or losses. A capital gain or loss arises when an
asset such as a stock or bond is sold or exchanged. If the selling price is greater than
the acquisition or purchase price, then the transaction yields a capital gain.
Conversely, a capital loss results when the selling price is less than the purchase
price. Capital assets held longer than 12 months and then sold or exchanged give rise
to long-term capital gains or losses, whereas sales or exchanges of capital assets held
one year or less produce short-term capital gains or losses. Short-term capital gains
are considered ordinary income and thus are taxed at regular income tax rates. By
contrast, long-term capital gains are considered capital income and thus are taxed at


21 See Robert Libby, Patricia A. Libby, and Daniel G. Short, Financial Accounting (Chicago:
Irwin, 1996), p. 111.
22 Joint Tax Committee, Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010,
p. 35

rates of 15% for individual taxpayers in income tax brackets above 15% and 5% for
individual taxpayers in the 10% and 15% income tax brackets.23
Under IRC Section 1202, non-corporate taxpayers (including partnerships,
LLCs, and S corporations) may exclude 50% of any gain from the sale or exchange
of qualified small business stock (QSBS) that has been held for more than five years.
The exclusion rises to 60% if the QSBS has been issued by a corporation based in an
empowerment zone. There is a cumulative limit on the gain from stock issued by a
single qualified corporation that may be excluded: in a tax year, the gain is limited
to the greater of 10 times the taxpayer’s adjusted basis of all QSBS issued by the firm
and disposed of during the year, or $10 million — reduced by any gains excluded by
the taxpayer in previous years. The remaining gain is taxed at a fixed rate of 28%.
As a result, the marginal effective tax rate on capital gains from the sale or exchange
of QSBS held for over five years is 14%. For individuals subject to the AMT, a
portion of the excluded gain is treated as an individual AMT preference item, which
means that it must be included in the calculation of AMT taxable income. The
portion is 42% for QSBS acquired on or before December 31, 2000 and disposed of
by May 6, 2003, 28% for QSBS acquired after December 31, 2000 and no later than
May 6, 2003, and 7% for QSBS acquired after May 6, 2003 and by December 31,

2008.24


To qualify for the partial exclusion, small business stock must satisfy certain
requirements. First, it must be issued after August 10, 1993 and must be acquired by
the taxpayer at its original issue, either directly or through an underwriter, in
exchange for money, property, or as compensation for services rendered to the issuer.
Second, the stock must be issued by a domestic C corporation whose gross assets do
not exceed $50 million before and immediately after the stock is issued. Third, at
least 80% of the corporation’s assets must be tied to the active conduct of one or
more qualified trades or businesses during “substantially all” of the five-year holding
period. Assets linked to working capital, start-up activities, or research and
development meet the active business test even if they are devoted largely to the
development of future assets or lines of business. Specialized small business
investment companies licensed under the Small Business Investment Act of 1958
also meet the active business test, making their stock eligible for the partial
exclusion.
Some small firms cannot benefit from the partial exclusion. Specifically, stock
issued by small C corporations primarily engaged in one of the following commercial
activities does not qualify for the partial gains exclusion: health care, law,


23 Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-
27), the 15% rate applies to assets sold or exchanged after May 6, 2003 and before January
1, 2009; and the 5% rate to assets sold or exchanged after May 6, 2003 and before January
1, 2008. In 2008, long-term capital gains received by taxpayers in the 10% and 15% income
tax brackets are exempt from taxation, making the rate 0%. Assuming no change in current
tax law, beginning in 2009 and thereafter, the maximum long-term capital gains tax rates
will rise to 20% for taxpayers in income tax brackets above 15% and 10% for taxpayers
subject to marginal rates of 10% and 15%.
24 The 7% rate stems from a provision in JGTRRA.

engineering, architecture, hospitality, farming, insurance, finance, and mineral
extraction. And stock issued by the following domestic C corporations is not eligible
for the partial exclusion: current or former domestic international sales corporations
(DISCs), regulated investment companies (RICs), real estate investment trusts
(REITs), real estate mortgage investment conduits (REMICs), financial asset
securitization investment trusts (FASITs), cooperatives, or C corporations that have
claimed the possessions tax credit under IRC Section 936.
The partial exclusion for QSBS is intended to make it easier for small start-up
firms in a variety of industries to raise equity capital, despite considerable uncertainty
or skepticism among investors about their growth potential and future prospects for
commercial success. It does this by increasing the potential after-tax returns an
investor can earn on sales or exchanges of QSBS, relative to potential after-tax
returns on other investment opportunities, over five years.
JGTRRA substantially diluted the investment incentive provided by the partial
exclusion. Before the act, the maximum tax rates on long-term capital gains were
20% on assets held for at least one year and 18% for assets acquired after December
31, 2000 and held for more than five years, while the effective tax rate on capital
gains realized on sales or exchanges of QSBS was 14%. Though JGTRRA unified
and lowered the maximum tax rate on long-term capital gains to 15%, it made no
compensatory change in the taxation of capital gains on QSBS.
An estimated $270 million in revenue was not be collected in FY2007 because
of the exclusion.25
Losses on Small Business Investment Company Stock Treated as
Ordinary Losses without Limitation. Generally, losses on stock investments
are treated as capital losses for tax purposes. These losses may be used to offset any
capital gains in the same tax year, but individuals may use capital losses to offset no
more than $3,000 of ordinary income in a single tax year.
Under IRC Section 1242, however, individuals who invest in small business
investment companies (SBICs) are permitted to deduct from ordinary income all
losses from the sale or exchange or worthlessness of stock in these companies. This
treatment is intended to foster private equity investment in these companies by
lowering the potential after-tax loss on an investment in a SBIC, relative to potential
after-tax losses on alternative investments.
SBICs are private regulated investment corporations that are licensed under the
Small Business Investment Act of 1958 to provide equity capital, long-term loans,
and managerial guidance to firms with a net worth of less than $18 million and less
than $6 million in average net income over the previous two years. They use their
own capital and funds borrowed with a SBA guarantee to make equity and debt


25 U.S. Office of Management and Budget, Budget of the United States Government, Fiscal
Year 2008: Analytical Perspectives (Washington: GPO, 2007), table 19-1, p. 288.

investments in qualified firms. For tax purposes, most SBICs are treated as C
corporations. In FY2002, SBICs provided $2.5 billion in financing for 2,610 firms.25
There are no known estimates of the revenue loss associated with this small
business tax benefit.
Rollover of Gains into Specialized Small Business Investment
Companies. In general, gains or losses on the sale or exchange of stocks are
recognized for tax purposes in the same year they are realized.
But under IRC Section 1044, which entered the federal tax code through the
Omnibus Budget Reconciliation Act of 1993, individual and corporate taxpayers who
satisfy certain conditions are allowed to roll over, free of tax, any capital gains on the
sale of publicly traded securities. The proceeds from the sale must be used to
purchase common stock or partnership interests in specialized small business
investment companies (SSBICs) licensed under the Small Business Investment Act
of 1958 within 60 days of the sale. SSBICs are similar to SBICs except that SSBICs
are required to invest in small firms owned by individuals who are considered
socially or economically disadvantaged — mainly members of minority groups. If
the proceeds from the sale exceed the cost of the SSBIC stock or partnership interest,
the excess is recognized as a capital gain and taxed accordingly. The taxpayer’s basis
in the SSBIC stock or partnership interest is reduced by the amount of any gain from
the sale of securities that is rolled over. The maximum gain that an individual can
roll over in a single tax year is the lesser of $50,000 or $500,000 less any gains
previously rolled over under this provision. For corporations, the maximum deferral
in a tax year is $250,000 or $1 million less any previously deferred gains.
There are no known estimates of the revenue loss associated with this small
business tax benefit.
Ordinary Income Treatment of Losses on Sales of Small Business
Stock. IRC Section 1244 allows taxpayers to deduct any loss from the sale,
exchange, or worthlessness of small business stock as an ordinary loss, rather than
a capital loss. For business taxpayers, ordinary losses are treated as business losses
for the sake of computing a net operating loss.
To qualify for this treatment, the stock must satisfy four criteria. First, it must
be issued by a domestic corporation after November 6, 1978. Second, the stock must
be acquired by an individual investor or his or her partnership in exchange for money
or other property, but not stock or securities. Third, the stock must be issued by a
small business corporation, which the statute defines as a corporation whose total
amount of money and property received as a contribution to capital and paid-in
surplus does not exceed $1 million when it issues the stock. Finally, during the five
tax years before loss on the stock is recognized, the firm must have derived more
than 50% of its gross receipts from sources other than royalties, rents, dividends,
interest, annuities, and stock or security transactions. The maximum amount that


25 See the website for the U.S. Small Business Administration’s SBIC program:
[ h t t p : / / www.s b a . go v/ INV / ] .

may be deducted as an ordinary loss in a tax year is $50,000 (or $100,000 for a
couple filing jointly).
This special treatment produced an estimated revenue loss of $50 million in
FY2007.26
Uniform Capitalization of Inventory Costs
Firms that earn income from the production, purchase, or sale of merchandise
are required to maintain inventories in order to determine the cost of goods sold
during a tax year. This cost is then subtracted from gross receipts in the computation
of their taxable income. In most cases, the cost of goods sold is calculated by adding
the value of a firm’s inventory at the beginning of the year to purchases of inventory
items made during the year and subtracting from that total the value of the firm’s
inventory at the end of the year.
IRC Section 263A requires business taxpayers engaged in the production of real
or tangible property, or in the purchase of real or tangible and intangible property for
resale, to “capitalize” (or include in the estimated value of their inventories) both the
direct costs of the property included in inventory and the indirect costs that can be
allocated to it. This requirement is known as the uniform capitalization rule and was
added to the tax code by the Tax Reform Act of 1986. In general, direct costs are the
material and labor costs arising from the production or acquisition of goods, and
indirect costs are the other costs incurred through the production or acquisition of
goods (e.g., repair and maintenance of equipment and facilities, utilities, insurance,
rental of equipment, land, or facilities, and certain administrative costs). Taxpayers
have some discretion in allocating indirect costs to production or resale activities, as
long as the methods used in the allocation produce reasonable and defensible results
for their trade or business.
Some small firms are exempt from the uniform capitalization rule. Specifically,
it does not apply to tangible or intangible property acquired for resale by a business
taxpayer with average annual gross receipts of $10 million or less in the previous
three tax years.
This exemption is advantageous because eligible firms face lower administrative
costs and less complexity in complying with income tax laws and have more control
over the timing of business expense deductions, creating opportunities for the
deferral of income tax liabilities.27
There are no known estimates of the revenue loss associated with this small
business tax benefit.


26 Office of Management and Budget, Budget of the U.S. Government in Fiscal Year 2008,
table 19-1, p. 288.
27 See Paul G. Schloemer, “Simplifying the Uniform Inventory Capitalization Rules,” Tax
Notes, vol. 53, no. 9, Dec. 2, 1991, pp. 1065-1069.

Simplified Dollar-Value LIFO
Accounting Method for Small Firms
Business taxpayers that maintain inventories to determine the cost of goods sold
in a tax year must estimate the value of their inventories at the beginning and end of
each tax year. Because it is time-consuming and costly to do this item by item, many
taxpayers use methods that assume certain item or cost flows.
One such method is known as “last-in-first-out”(or LIFO). LIFO assumes that
the most recently acquired goods are sold first. Consequently, LIFO allocates the
newest unit costs to the cost of goods sold and the oldest unit costs to the ending
inventory. The method can be advantageous to use when the cost of many inventory
items is rising, because LIFO yields a lower taxable income and inventory valuation
than other methods. There are various ways to apply LIFO. A widely used
application is known as the dollar-value method. Under this method, a taxpayer
accounts for its inventories on the basis of a pool of dollars rather than item by item.
Each pool includes the value of a variety of inventory items and is measured in terms
of the equivalent dollar value of the inventory items at the time they were first added
to the inventory account, or the base year. Using the dollar-value method is28
complicated and costly for most taxpayers.
But IRC Section 474, which was established by the Tax Reform Act of 1986,
allows some small firms to use a simplified dollar-value LIFO method. It differs
from the regular dollar-value method in the way in which inventory items are pooled,
and in the technique for estimating the base-year value of the pools. A firm is
eligible to use the simplified method if its average annual gross receipts were $5
million or less in the three previous tax years.
There are no known estimates of the revenue cost of this small business tax
benefit.
Tax Credit for Pension Plan Start-Up Costs of Small Firms
Under IRC Section 45E, qualified small firms may claim a non-refundable tax
credit for a portion of the start-up costs involved in setting up new retirement plans
for employees. The credit, which was enacted as part of the Economic Growth and
Tax Relief Reconciliation Act of 2001, began in 2002 and originally was scheduled
to disappear (or “sunset”) after 2010. Section 811 of the Pension Protection Act of
2006 permanently extended the credit. It is a component of the general business
credit and thus subject to its limitations and rules for carryover.
The credit is equal to 50% of the first $1,000 in eligible costs incurred in each
of the first three years of a qualified pension plan’s existence. Eligible costs are
defined as the ordinary and necessary expenses incurred in connection with the


28 For more details on this method, see U.S. Congress, Joint Committee on Taxation, Impact
on Small Business of Replacing the Federal Income Tax, JCS-3-96 (Washington, Apr. 23,

1996), pp. 18-19.



administration of the plan and the education of employees about the plan’s benefits
and requirements. Qualified plans include new defined benefit plans, defined
contribution plans, savings incentive match plans for employees, and simplified
employee pension plans. Firms with fewer than 100 employees who received at least
$5,000 in compensation in the previous year are eligible to claim the credit. They
can do so only if at least one highly compensated employee participates in the plan.
The credit is intended to give owners of small firms that never have offered
retirement benefits to employees a robust incentive to establish pension plans for
employees by reducing the after-tax cost of setting up and administering these plans
in their early years. Recent surveys have indicated that these costs often constitute
a formidable barrier to the creation of pension plans among small employers.
The Joint Committee on Taxation has estimated that less than $50 million in
revenues was foregone in FY2007 because of the credit.29
Magnitude of Small Business Tax Benefits
By now it should be clear that the federal tax code encourages the formation of
small firms and fosters their growth in a variety of ways. What is not clear is the
extent to which the tax code generally favors smaller firms over larger ones.
Answering this question raises difficult analytical issues that go beyond the scope of
this report. Nonetheless, it is possible to illustrate the potential magnitude of specific
small business tax preferences.
Consider the expensing allowance under IRC Section 179. In the minds of
many, the allowance epitomizes small business tax subsidies, even though its revenue
cost can be much lower than that of some other small business tax preferences and
many firms outside manufacturing derive little or no benefit from it. In a 1995 study,
Douglas Holtz-Eakin analyzed the effect of the expensing allowance on a firm’s user
cost of capital. As noted earlier, expensing stimulates business investment by
reducing the user cost of capital. Table 1 summarizes his findings.30 The first
column gives the assumed corporate tax rate; the second shows the required pre-tax
rate of return if the entire cost of the investment is expensed; the third provides the
required pre-tax rate of return if the entire cost is recovered through the depreciation
allowances allowed under federal tax law in the early 1990s; and the final column
displays the effective tax subsidy from expensing, which is expressed as the
difference (in percentage points) between the required rates of return shown in
columns three and two.
At least two conclusions can be drawn from the results. First, expensing
constituted a significant investment subsidy, and the extent of the subsidy rose with


29 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years

2006-2010, p. 40.


30 Douglas Holtz-Eakin, “Should Small Businesses Be Tax-Favored?,” Tax Notes, vol. 48,
No. 3, Sept. 1995, p. 389. (In 2003, Dr. Holtz-Eakin was named the Director of the
Congressional Budget Office.)

a firm’s marginal tax rate. For example, at a tax rate of 15%, expensing lowered the
user cost of capital by about 11%; but at a rate of 35%, the reduction jumped to 28%.
Second, the user cost of capital under expensing fell as the tax rate increased because
tax deductions became increasingly valuable at higher tax rates.
Table 1. Estimated User Cost of Capital Under-Expensing
(%)
Corporate TaxExpensingRegularSize of Subsidy
Rat e Depreciation

15% 17.95% 20.23% 2.28a


25 17.05 21.13 4.08
35 16.15 22.40 6.25
Source: Douglas Holtz-Eakin, “Should Small Business Be Tax-Favored?, National Tax Journal,
Sept. 1995.
a Percentage points, not percent.
Note: The calculations assume an interest rate of 9%, an inflation rate of 3%, and a rate of economic
depreciation of 13.3%. The following formula is used to compute the user cost of capital:
/ = (-cqpdttzπ+/1−)×(1,)
where c is the annual value of revenue from the investment, q is the purchase price of the capital
good, p is the after-tax financial cost of capital, pi is the rate of inflation, d is the rate of geometric
depreciation, t is the marginal tax rate, and z is the present value of depreciation allowances per
dollar of investment. In the case of expensing, z = 1.0; and in the case of regular depreciation, z =
0.2814.
Economic Role of Small Firms
Available data on the economic role of small firms indicate they make
significant contributions to the U.S. economy. A critical consideration in assessing
those contributions is the definition of a small firm. When small firms are defined
as independent business enterprises with fewer than 500 employees, they account for
over 99% of employers, more than 50% of private non-farm employment, about 47%
of private non-farm compensation (wages, salaries, and benefits), and over 50% of31
nominal gross domestic product (GDP) in 2004. The economic importance of small
firms varies by industry. In 2002, the share of an industry’s contribution to GDP
accounted for by firms with fewer than 500 employees ranged from 20% for
information to 85% for other services.32 In addition, small firms generate a large
share of the new domestic jobs created each year. According to data reported by the


31 Small Business Administration, Office of Advocacy, Frequently Asked Questions
(Washington: August 2007), and Katherine Kobe, The Small Business Share of GDP, 1998-

2004, report for the Small Business Administration (Washington: Apr. 2007), pp. 7 and 13.


32 Katherine Kobe, The Small Business Share of GDP, 1998-2004, p. 7.

Bureau of Labor Statistics, firms with less than 500 employees accounted for 65%
of net new job creation in the non-farm private sector, from the third quarter of 1992
through the first quarter of 2005.33
Most firms start out small in employment size, and their chances of eventually
growing into large successful firms are less than promising. Two-thirds of new firms
survive at least two years, and 44% last at least four years.34 Or, looking at it from the
flip side, well over one half don’t survive into their fifth year. Thus, while hundreds
of thousands of new firms come into existence annually, hundreds of thousands
existing firms cease functioning. This constant churning is reflected in the
fluctuating contributions of small firms to annual net job creation.
Small firms also make important contributions to the process of technological
innovation. According to a 2003 study by CHI Research, Inc., firms with fewer than
500 employees accounted for 41% of all patents filed by U.S. corporations from 1996
to 2000, and firms of that size produced 13 to 14 times as many patents per employee
as comparable large firms.35 The researchers also found that small firms filed 25%
of the patents related to biotechnology, 19% of the patents related to pharmaceuticals,
11% of the patents related to medical equipment and electronics, and 9% of the
patents related to chemicals other than pharmaceuticals.36
Economic Arguments For and Against Small
Business Tax Preferences
The economic importance of small firms as a whole calls into question the
underlying economic rationale for existing small business tax subsidies and proposals
to enhance them or add new ones. It is fair to ask why the subsidies are needed if
small firms normally account for substantial shares of domestic employment and
output and play vital roles in the commercial development of new technologies.
The answer to this question has implications for U.S. social welfare, as small
firms received over $11 billion in tax benefits in FY2007 — in addition to the
financial support they receive through other federal programs intended to aid small
business. If the economic arguments made in favor of these tax subsidies turn out to
be weak or untenable, then using these resources for other applications (e.g., reducing
the federal budget deficit or raising federal spending on public education or basic
research) may lead to better economic outcomes for a greater numbers of firms and
individuals.


33 Department of Labor, Bureau of Labor Statistics, New Quarterly Data from BLS on
Business Employment Dynamics by Size of Firm (Washington: Dec. 2005), p. 3.
34 Small Business Administration, Frequently Asked Questions, Aug. 2007.
35 CHI Research, Inc., Small Serial Innovators: The Small Firm Contribution to Technical
Change, report for the Small Business Administration (Washington: 2003), p 3.
36 Ibid., p. 17.

In evaluating the economic arguments made in favor of small business tax
benefits, it should be recognized that persuasive non-economic arguments can be
made in favor of these benefits. Some lawmakers may assign a greater weight to
those arguments than any economic argument.
Nevertheless, the central focus of this section is the economic arguments for and
against such proposals and their merits. These arguments are discussed below.
Chief Economic Arguments in Favor of the Preferences
Proponents of small business tax subsidies generally cite four economic
justifications for them: (1) the special economic role played by small firms; (2) the
formidable barriers to their formation and growth in financial markets; (3) the impact
of relatively high marginal tax rates on the formation of small firms, and (4) the
unique opportunities for individual economic advancement offered by small business
ownership. Each is examined in some detail here.
Special Economic Role of Small Firms. As surprising as it may seem, the
economic contributions of small firms are often cited as reasons to provide federal
support for small business. For example, in his 2001 Senate floor remarks calling for
additional tax benefits for small firms, Senator Christopher Bond noted that “small
businesses represent more than 99% of all employers, employ 53% of the private
work force, create about 75% of the new jobs in this country, ... contribute 47% of
all sales in this country, and ... are responsible for 51% of private gross domestic
product.”37 Similarly, Senator Olympia Snowe asked for more tax benefits for small
firms in a 2003 floor statement: “[T]hey (small businesses) represent 99% of all
employers, employ 51% of private-sector workforce, provide about 75% of the net
new jobs, contribute 51% of the private-sector output, and represent 96% of all
exporters of goods.”38
Proponents of small business tax subsidies also point to the gains in economic
efficiency, dynamic structural changes, and important technological innovations often
attributed to small firms as justifications for the subsidies.
The gains in economic efficiency are thought to lie in evidence that small firms
supply certain goods and services more efficiently than large firms. As economist
Bo Carlsson has noted, this advantage can be found in industries where large
production runs and falling unit costs are dominant structural features; examples
include computers, automobiles, and steel.39 In industries such as these, small and
large firms tend to specialize in different products or services. As a result, they often


37 Sen. Christopher Bond, remarks in the Senate, Congressional Record, daily edition, vol.

147, Jan. 25, 2001, p. S576.


38 Sen. Olympia Snowe, remarks in the Senate, Congressional Record, daily edition, vol.

149, no. 6, Jan. 14, 2003, p. S299.


39 Bo Carlsson, “Small Business, Entrepreneurship, and Industrial Dynamics,” in Are Small
Firms Important? Their Role and Impact, Zoltan J. Acs, ed. (Boston: Kluwer Academic
Publishers, 1999), p. 100.

end up interacting more as close collaborators than as fierce competitors. In
Carlsson’s view, the dramatic rise in outsourcing among large U.S. firms in the
1990s had the effect of further hardening this division in labor between large and
small firms. Among the reputed advantages of small firms in the vast and complex
chain of supply undergirding the U.S. economy is greater flexibility in responding to
new market opportunities and competitive threats.
The belief that small firms can serve as powerful agents of dynamic economic
change and technological advance appears rooted in the critical roles played by small
start-up firms in the origins and rapid growth of certain high-technology industries
like computers and microelectronics. Two notable findings in the recent literature
on firm size and technological innovation are the contribution of small firms to
innovation seems to vary by industry, and that their contributions are likely to be
most significant in relatively young industries with relatively low levels of
concentration.40 The same literature offers some fresh evidence that in certain
industries small start-up firms are more adept than large established firms at
identifying promising commercial applications for new technologies and exploiting
these opportunities. During the 1980s and 1990s, many striking examples of this
competitive advantage emerged in biotechnology, microelectronics, computer
software, and electronic commerce.41
Experiences such as these have led some economists to conclude that small
entrepreneurial firms collectively serve as a vital and indispensable source of
economic growth and renewal. They contend that economic growth is marked by the
continuous creation and destruction of jobs and firms, and that small entrepreneurial
firms inject needed innovation and competition into this process. Carlsson has
claimed that without the “heterogeneity and volatility” provided by small start-up
firms, “the economy eventually stagnates or even collapses.”42
Opportunities for the Social and Economic Advancement of
Immigrants, Women, and Members of Minority Groups. Proponents of
small business tax subsidies also cite the benefits of small business ownership for
women, minority groups, immigrants, and the communities where they reside as an
important justification for the subsidies. They argue that owning and managing a
small business gives them access to the social and economic mainstream in the
United States. In addition, proponents claim that women-, minority-, and immigrant-
owned small firms benefit their immediate communities and society at large in ways
that go beyond direct economic effects.
There is evidence that female small business owners are more likely than their
male counterparts to encourage openness in workplace communication and decision-
making, hire a diverse workforce, put into place desirable child-care programs, and
pay full benefits to employees. In addition, families with self-employed women who


40 Joshua Lerner, “Small Business, Innovation, and Public Policy,” in Are Small Firms
Important? Their Role and Impact, p. 160.
41 Ibid., p. 160.
42 Bo Carlsson, “Small Business, Entrepreneurship, and Industrial Dynamics,” p. 109.

work out of their homes are more stable than the average family.43 And in the case
of minority and immigrant groups, small business ownership helps to build tight-knit
social networks, providing job and skills training, and creating informal capital
market s.44
Imperfections in Capital Markets. Yet another economic argument made
in favor of small business tax subsidies is that they can ease or offset the barriers
faced by many small business owners and aspiring entrepreneurs to raising funds to
start or expand a business. If capital markets were truly efficient, then every small
business investment opportunity offering a rate of return above the cost of capital
would obtain the needed funding, regardless of the creditworthiness of the owners.
But proponents of government support for small business say that such is not the
case. In their view, many potential and current entrepreneurs are unable to borrow
or attract equity capital, largely because of inadequate information on the part of
lenders and investors. As a consequence, small business owners facing such a
constraint often are forced to finance projects out of their own resources or the
resources of friends and family members, or to abandon the projects altogether.
Small business owners facing severe liquidity constraints have an elevated risk of
failure.
Impact of Progressive Income Taxes. Supporters of tax relief for small
firms also maintain that taxes have a significant effect on three key decisions made
by any small business owners: how fast to grow the firm; whether to expand capital
investment — and if so, by how much; and whether to hire more employees — and
if so, how many? They cite a variety of studies suggesting that as individual or
corporate tax rates rise, small firms grow at a slower rate, invest less in new tangible
and intangible assets, and become increasingly less likely to expand employment.45
In their view, these effects, especially when contrasted with the economic
contributions of small firms (especially those that can rightly be called
entrepreneurial), offer a compelling argument in favor of granting/offering tax breaks
to these firms.
Chief Economic Arguments Against the Subsidies
While acknowledging the significant economic role played by small firms, some
analysts maintain it cannot serve as a justification for targeting tax subsidies at small
firms. Conventional economic analysis holds that government intervention in the
economy is warranted mainly to correct some kind of market failure. In general,


43 See Candida Brush and Robert D. Hisrich, “Women-Owned Businesses: Why Do They
Matter?,” in Are Small Firms Important? Their Role and Impact, pp. 111-127.
44 See John Sibley Butler and Patricia Gene Greene, “Don’t Call Me Small: The
Contribution of Ethnic Enterprises to the Economic and Social Well-Being of America,” in
Are Small Firms Important? Their Role and Impact (Boston: Kluwer Academic Publishers,

1999), pp. 129-145.


45 Douglas Holtz-Eakin and Harvey Rosen, Economic Policy and the Start-up, Survival, and
Growth of Entrepreneurial Ventures, report submitted to the Small Business Administration,
May 2001, pp. 43-44.

market failures can be thought of as conditions that prevent or unduly retard the
emergence of economically efficient outcomes. Foremost among these conditions
are a lack of perfect competition, the presence of public goods, positive or negative
external effects (or externalities), the existence of incomplete markets, and imperfect
information on the part of consumers.46 Critics of small business tax subsidies say
there is no evidence that a market failure stands in the way of the formation or growth
of small firms. Moreover, by their way of thinking, such subsidies are likely to lead
to undesirable equity and efficiency effects.
Equity Concerns. Proponents of small business tax preferences generally do
not refer to their equity effects in defending them on economic grounds.
But critics maintain no such silence. In their view, small business tax
preferences undercut the progressivity of the federal individual income tax. Under
a progressive income tax, an individual’s tax liability depends on his or her income
so that taxpayers with higher taxable incomes pay higher taxes than taxpayers with
lower taxable incomes. But small business tax preferences weaken the link between
tax burden and income by reducing the tax burden on the earnings of small firms. It
is an axiom of public finance that individuals, and not firms, ultimately bear the
burden of business income taxes. While all owners of capital can be expected to
benefit from small business tax preferences, most of those benefits presumably end
up in the hands of small business owners, whose income and wealth tend to be well47
above average for U.S. households.
Efficiency Concerns. Critics also criticize small business tax subsidies on
efficiency grounds. In theory, income taxes reduce social welfare by distorting the
behavior of consumers and firms. As a result, the most desirable income taxes are
those that raise the needed revenue without preventing economic resources from
flowing to their most productive uses.
This doctrine of neutrality has important implications for tax policy. First, it
implies that the returns to all investments should be taxed at the same rate. Second,
the doctrine implies that any tax that is not uniform across firms may cause social


46 For more information on market failures, see Joseph E. Stiglitz, Economics of the Public
Sector, 3rd Edition (New York: W.W. Norton & Co., 2000), pp. 76-90.
47 According to a 1990 study by Charles Brown, James Hamilton, and James Medoff, the
average family owning a small business had an income that was 80% greater and wealth that
was five times greater than the average family. (See Charles Brown, James Hamilton, and
James Medoff, Employers Large and Small (Cambridge, MA: Harvard University Press,
1990), pp. 15-17.) More recently, in a study of the wealth and income of U.S. small
business owners from 1992 to 2001, researchers George W. Haynes and Charles Ou found
that, in 2001, the mean income of households with small business owners was $110,370,
compared to $42,108 for households with no business owners, and the mean net worth of
households with small business owners was $1,050,872, compared to $188,535 for
households with no business owners. (See George W. Haynes and Charles Ou, How Did
Small Business-Owning Households Fare During the longest U.S. Economic Expansion?,
report prepared for the Small Business Administration (Washington: June 2006) table 3, p.

26.



welfare to be less than optimal.48 Finally, it implies that taxes should not distort a
firm’s choice of inputs or its investment or production decisions.
Small business tax preferences, say critics, violate each of these policy
prescriptions. In their view, an efficient or desirable allocation of resources can be
achieved only if the tax code does not favor small firms over large firms, or
unincorporated firms over incorporated firms, or interfere with the natural growth
and evolution of firms, or encourage firms to attain a particular asset, employment,
or revenue size and remain there.49
A departure from the doctrine of neutral taxation to assist small firms might be
warranted if there were something uniquely valuable about the economic role of such
firms that can flourish only through targeted government support. Proponents of
small business tax preferences claim that small firms consistently create more jobs
and spawn more important technological innovations than large firms, and that
government support in the guise of tax subsidies is needed to ensure that they
continue to play these roles. But critics question both the premises and policy
recommendation of this argument.
Critics and proponents alike agree that small firms generally are a robust source
of job creation. According to data from the Small Business Administration, small
firms created between half and three-quarters of all new jobs from 1990 to 1997,
depending on how the employment size of a small firm is specified.50
Critics maintain, however, that for a variety of reasons these data do not
necessarily prove that small firms have a greater job-creating prowess than large
firms. To begin with, they note that the data raise more questions than they answer:
What does it mean to be small? When should a firm’s size be measured? Is gross
or net job creation a better indicator of job-creating prowess? And how long should
a job last before it is counted as a new job?
In addition, critics say there is an abundance of evidence that small firms are not
demonstrably and consistently better at creating jobs than large firms. First, there
appears to be considerable variation over time in the share of new jobs created by
small firms. In a widely cited study, David Birch and James Medoff estimated that
the share of total net new jobs generated by firms employing 100 or fewer workers
varied from about 40% to 140%, depending on the stage of the business cycle.51


48 Stiglitz, Economics of the Public Sector, pp. 567-569.
49 Douglas Holtz-Eakin, “Should Small Businesses be Tax-Favored?,” National Tax Journal,
vol. 48, no. 3, Sept. 1995, p. 390.
50 U.S. Small Business Administration, Office of Advocacy, Small Business FAQ,
(Washington: Dec. 2000).
51 See David Birch and James Medoff, “Gazelles,” in Labor Markets, Employment Policy,
and Job Creation, Lewis C. Solomon and Alec R. Levenson, eds. (Boulder, CO: Westview
Press, 1994), p. 162. The share of net new jobs created by firms with 100 or fewer workers
can exceed 100% in a year if these firms create more jobs than they destroy, all other firms
(continued...)

Second, most jobs created by small firms are created by new firms, which typically
start out small in employment or asset size. Yet many of these jobs do not last a long
time because most new firms fail within their first few years.52 Third, a few firms
accounted for most small business job creation between the late 1980s and early
1990s — Birch and Medoff labeled these firms “gazelles” — and these firms grew
swiftly from small to large, and in some cases from large back to small, suggesting
that their job-creating ability was unstable at best.53 Finally, during the 1970s and
1980s, large firms and plants dominated job creation and destruction in the
manufacturing sector, and there was no strong, systematic relationship between firm
size and net job growth rates.54
Critics also contend that even if small firms were to create more jobs than large
firms over time, there is no reason to think that government support for small
business would lead to faster employment growth. Economic analysis indicates that
the economy generates jobs through what can be described as a natural process of
growth, decline, and structural change; the size distribution of firms seems irrelevant
to this process. From this perspective, the level of national employment results from
a mix of factors that would swamp the employment effects of any government
support for small business. The key factors are fiscal and monetary policy, consumer
spending, business investment, and the difference between U.S. exports and imports.
Research and development (R&D) is the lifeblood of technological innovation,
which, in turn, serves as a primary engine of long-term economic growth.
Economists generally agree that without government support, business investment
in R&D would fall short of the socially optimal amount. Left to their own devices,
firms are likely to invest too little in R&D for two reasons. One is that they cannot
capture all the returns to R&D investment, mainly because other firms are able to
capitalize on the results of research in spite of available intellectual property
protection. A second reason is that some firms lack access to sufficient capital to
invest in R&D because they are unwilling or unable to provide investors with the
information they require to evaluate the potential returns on planned R&D
investments.55 This tendency to invest too little in R&D represents a market failure
in that too few resources are allocated to R&D in light of its potential economic


51 (...continued)
destroy more jobs than they create, and the net job gain arising from the former exceeds the
net job loss arising from the latter. For example, if firms with 100 or fewer employees
account for a net job gain of 100 and all other firms generate a net job loss of 25, then the
economy as a whole would realize a net job gain of 75, and the share of that gain attributable
to firms with 100 or fewer employees would be 133%.
52 Ibid., p. 8.
53 Birch and Medoff, “Gazelles,” pp. 162-164.
54 Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction
(Cambridge, MA: MIT Press, 1996), pp. 169-170.
55 Scott J. Wallsten, “Rethinking the Small Business Innovation Research Program,” in
Investing in Innovation: Creating a Research and Innovation Policy That Works, Lewis M.
Branscomb and James H. Keller, eds. (Cambridge, MA: MIT Press, 1998), p. 197.

benefits. To remedy this failure, many economists recommend government
intervention to encourage business R&D investment.
But critics of small business tax subsidies maintain that it is far from clear that
government support for this investment should be targeted at small firms. They point
to abundant evidence suggesting that both small and large firms launch the
innovations that help propel the processes of economic growth and structural change,
and that it is impossible to disentangle the contributions of one group from the other.
According to data reported by the National Science Foundation (NSF), larger firms
perform the vast share of business R&D: from 1992 to 1997, for example,
companies with fewer than 500 employees accounted for 14% of total business R&D
spending, whereas companies with 10,000 or more employees were responsible for

59% of these expenditures.56


Nonetheless, small firms and large firms each appear to have distinct advantages
as agents of technological innovation.57 In addition, numerous studies have looked
at the effects of firm size and market structure on innovation.58 On the whole, they
have found that no firm size is ideal for generating new successful commercial
technologies. Rather, there is evidence that in some industries, small firms were
more innovative than large firms, but in other industries, large firms had a decisive
edge in the generation of new technologies.
Other Concerns. Critics also question the suitability and effectiveness of
some current or proposed small business tax subsidies.
One argument made in favor of these subsidies is that the creation of new small
firms is needed to prevent the development of monopoly power by large firms. But
critics contend that the best way to achieve such a policy goal does not involve
government support for the formation and growth of small firms. They point out that
only a tiny share of small start-up firms survive and grow large enough to pose a
serious competitive threat to large entrenched firms in the same industry. In the view
of critics, antitrust law is a more effective policy tool than small business tax
subsidies for preventing the rise of monopoly power and other anti-competitive
business practices.


56 National Science Board, Science & Engineering Indicators — 2000, Vol. 1 (Arlington,
VA: 2000), appendix table 2-54, pp. A-97 and A-98.
57 On the one hand, small firms may have a greater potential than large firms to create
or dominate a new industry through R&D and may be more flexible than large firms
in the pursuit of promising R&D projects. On the other hand, large firms can more
easily cover the substantial sunken costs involved in conducting R&D and are more
likely to capture a large share of the returns to R&D investments through marketing
campaigns, the protection of intellectual property rights, and the creation of regional,
national, and international distribution and service and repair networks. See Wallsten,
“Rethinking the Small Business Innovation Research Program,” p. 197.
58 F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance,

3rd edition (Boston: Houghton Mifflin Co., 1990), pp. 651-657.



Critics also note that if the aim of public policy is to stimulate employment
growth, then it makes little sense to offer small firms tax subsidies that lower the cost
of capital. The current expensing allowance is a case in point. Such a subsidy lowers
the cost of capital relative to labor, thereby encouraging small firms to substitute
machinery and equipment for labor. In theory, a tax subsidy like the allowance leads
to fewer workers being employed than would be the case in the absence of the
allowance.
Finally, critics argue that small business tax preferences should be avoided or
minimized because they impose an implicit or a hidden tax on business growth. This
tax has been described as the “notch problem,” and it is an inevitable result of the
design of many current tax preferences targeted at small firms. Under the typical
small business tax preference, firms lose the tax benefit when their workforce, assets,
or receipts surpass a certain limit specified by law. Such a design creates a
disincentive to grow beyond that limit.
The expensing allowance under IRC Section 179 illustrates this pitfall. In 2003,
the maximum allowance was $100,000 and the phaseout threshold was $400,000.
When a firm increased its investment that year in assets that qualified for the
allowance beyond $400,000, the amount that could be expensed was reduced dollar
for dollar, ultimately to zero when total investment reached $500,000. In effect, this
design gave firms an incentive to invest no more than $100,000 in qualified assets
in a single tax year. For any investment, the cost of capital depends in part on the
investor’s marginal tax rate. Jane Gravelle of CRS has estimated that under the
expensing allowance for 2003, the marginal effective tax rate on investment in
equipment was 0% on the first $100,000, 26% on amounts over $100,000 to
$400,000, 43% on amounts over $400,000 to $500,000, and 26% on amounts above
$500,000.59 Douglas Holtz-Eakin has pointed out that the design of the allowance
effectively raises a firm’s cost of capital at a time when its growth is boosting its
capital needs.60
Conclusions
There is no question that small firms make important contributions to the
performance and growth of the U.S. economy. Of course, the magnitude of the
contributions depends on how a small firm is defined. Under the definition used by
the SBA in administering its programs, it is fair to say that small business accounts
for a majority of private-sector jobs and private-sector output, generates many key
technological innovations, and serves as a potent agent of revitalization and structural
change in a variety of industries.


59 The estimate assumes a rate of inflation of 2% and a corporate tax rate of 35%. It is based
on a simulation done by Gravelle with the aid of the CRS capital stock model on May 9,

2003.


60 Holtz-Eakin, “Should Small Businesses Be Tax-Favored?,” p. 393.

These contributions may explain much of the strong backing inside and outside
Congress for government policies to assist small business. A prominent example of
such a policy is the preferential tax treatment received by many small firms. The
combined revenue cost of current federal small business tax subsidies, excluding the
tax treatment of passthrough entities, exceeded $11 billion in FY2007. A variety of
initiatives to expand these subsidies are being considered in the 110th Congress.
Mainstream economic analysis suggests that it is difficult to justify an expansion
of small business tax subsidies on equity or efficiency grounds. Small business tax
preferences reduce the tax burden on owners of small firms, diluting (to an unknown
extent) the progressivity of the federal individual income tax system. In addition, it
appears that small business tax preferences do little to advance social welfare.
Economic theory holds that the efficiency losses inevitably caused by income taxes
are minimized when taxes do not distort the production arrangements within firms
and all returns to capital are taxed at the same rate. Deviations from this theory of
uniform taxation are warranted to correct clear and obvious market failures. In the
case of small firms as a whole, there is no convincing evidence that some kind of
market failure is linked to their rates of formation and growth or to their performance
in a wide range of industries.
This is not to suggest that government support for small firms would never be
justified on economic grounds. If a market failure were to emerge that retards the
formation and growth of small entrepreneurial firms, government action to eradicate
the source of the failure would be warranted. One such market failure would be
imperfections in capital markets that impede the entry of new small entrepreneurial
firms or greatly diminish the chances of survival of existing small entrepreneurial
firms. Such a problem could be corrected through policy measures aimed at
expanding the flow of capital to small start-up firms but without greatly distorting the
allocation of capital within the economy at large. Tax subsidies might be useful in
this case, but to be effective, they would need to address the root causes of the capital
market imperfections. A continuing challenge for policymakers is to identify market
failures that disproportionately harm small firms and devise appropriate policy
responses.
The discussion presented here underscores the need for the development of a
robust model of the formation of small firms and their contributions to the economy.
As it now stands, considerable uncertainty surrounds these issues. Holtz-Eakin has
noted that the development of such a model would enable policymakers to determine
whether any market failures are interfering with the formation and growth of small
firms, identify the factors driving these failures, and develop policies that address
these factors.61


61 Ibid.