Order Code RL32254
CRS Report for Congress
Received through the CRS Web
Small Business Tax Benefits:
Overview and Economic Analysis
March 3, 2004
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Small Business Tax Benefits:
Overview and Economic Analysis
Summary
Congress has long taken an interest in the federal tax burden on small firms and
its effect on their performance and growth. This ongoing concern has led to the
enactment of numerous legislative initiatives over the years to reduce this burden.
The 108th Congress has already passed two bills with important implications for the
taxation of small firms and is considering a variety of other proposals to expand
current small business tax preferences or create new ones.
This report describes the principal federal tax benefits for small firms and
assesses possible economic rationales for them. It will be updated when any new
benefits are added to the tax code, or current ones are modified or repealed.
While the federal revenue cost of existing small business tax preferences is not
known, estimates by the Joint Committee on Taxation indicate that they exceeded
$6.6 billion in fiscal year 2003. According to available data on federal tax
expenditures, the small business tax benefits outside farming with the broadest
impact are 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 several interesting and important policy issues. For many
public finance economists, a key issue is whether or not they can be justified on
standard economic grounds. It can be argued that in the absence of such a foundation,
such proposals may lead to efficiency losses and decreased progressivity in the
federal tax code.
In general, proponents of current small business tax preferences claim that the
special economic role played by small firms and the barriers to their formation and
growth justify the use of such benefits. More specifically, they assert that there are
compelling economic reasons to favor or subsidize small firms through the tax code:
namely, the income, jobs, technological innovations, and opportunities for economic
renewal and structural change generated by small firms; the constraints on their
ability to raise capital in debt and equity markets; and the formidable competitive
advantages held by large, established firms.
While acknowledging the significant contributions made by small firms to
national income and employment, critics of small business tax preferences argue that
there appears to be no sound economic rationale for them. More specifically, in their
view, these subsidies lessen the progressivity of the federal income tax and produce
net efficiency losses. In addition, critics assert that regardless of these effects, some
current subsidies are either inappropriate or poorly designed, leading to perverse or
unanticipated outcomes.

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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 . . . . . . . . . . 6
Exemption of Certain Small Corporations From the Corporate
Alternative Minimum Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Amortization of Business Start-Up Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Cash Basis Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Tax Incentives for Private Equity Investment in Small firms . . . . . . . . . . . 11
Partial Exclusion of Capital Gains on Certain Small Business
Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Losses on Small Business Investment Company Stock Treated
as Ordinary Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Rollover of Gains into Specialized Small Business Investment
Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Losses on Small Business Stock Treated as Ordinary Losses . . . . . . . 14
Uniform Capitalization of Inventory Costs . . . . . . . . . . . . . . . . . . . . . . . . . 14
Simplified Dollar-Value LIFO Accounting Method for Small Firms . . . . . 15
Tax Credit for Pension Plan Start-Up Costs of Small Firms . . . . . . . . . . . . 16
Magnitude of Small Business Tax Benefits . . . . . . . . . . . . . . . . . . . . . . . . . 16
Economic Role of Small Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Economic Arguments For and Against Small Business Tax Subsidies . . . . . . . . 18
Chief Economic Arguments in Favor of the Subsidies . . . . . . . . . . . . . . . . 18
Chief Economic Arguments Against the Subsidies . . . . . . . . . . . . . . . . . . . 21
Equity Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Efficiency Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Other Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
List of Tables
Table 1. Estimated User Cost of Capital Under Expensing . . . . . . . . . . . . . . . . 17

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Small Business Tax Benefits:
Overview and Economic Analysis
Some policy issues seem to be permanent fixtures on the congressional
legislative agenda. One such issue is the federal tax burden on small firms and how
it affects their performance and growth prospects. Many policymakers view small
firms as a vital and essential source of job creation, economic opportunity, and
technological innovation and construe their taxation both as a drag on their growth
and a policy instrument for stimulating their formation and growth. Such a
perspective has helped to lay the foundation for the adoption of a variety of small
business tax benefits in recent decades. Current federal tax law contains a number
of provisions that confer preferential treatment on small firms. In addition, the 108th
Congress is considering a variety of proposals to lessen their tax burden by enhancing
some current small business tax preferences, creating new ones, or simplifying tax
administration and compliance for small firms.
Existing small business tax benefits and proposals to enhance or expand them
raise several important policy issues. One is the substantial resources transferred to
small firms through such subsidies and their long-term economic consequences. In
the minds of some policymakers, the long-term benefits of small business tax
subsidies outweigh their revenue cost, making them a wise investment of public
funds. Another key issue concerns whether these preferences can be justified on
economic grounds. If such a rationale cannot be found or appears tenuous at best,
then measures to expand small business tax preferences may end up harming the
performance of the economy 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, moves on to consider
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?
Before describing the ways in which the federal tax code favors small firms and
discussing the economic role of small firms, it is useful to gain an understanding of
how small firms are defined for tax purposes. Unfortunately, doing so is not a simple
and straightforward task. This is because there is no uniform definition of a small
firm in the many federal statutes conferring benefits on small business. Instead,
several criteria are employed to sort firms by size, and the criterion varies for reasons
that sometimes are less than transparent.

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CRS-2
This ambiguity has 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
state 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 which firms are eligible 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 programs lending support to small firms, federal agencies have
the choice of using SBA size standards and limits or establishing their own.
In general, three criteria are used to identify small firms eligible for federal
support. Each specifies the maximum size a firm (including affiliates) can attain and
still qualify for a particular program. For the most part, the SBA uses two criteria to
determine eligibility for the programs it administers: number of employees and
average annual receipts in the previous three years. The criteria vary by industry.
For example, the criterion for most manufacturing and mining firms is employment
size, and the upper limit is 500 employees; but for most retail and service firms, the
criterion is average annual receipts, and the upper limit is $6 million. SBA’s current
size limits for eligible 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 A third
criterion is a firm’s asset size. Under this size standard, eligible small firms own
assets up to a certain threshold, such as $50 million. Among the array of federal
programs granting special benefits to small business, use of this criterion appears
more limited than number of employees or average annual receipts.
How does the federal tax code define a small firm? Again, no simple answer
is possible because a variety of criteria are used to determine eligibility for the small
business tax preferences, and it is not clear why the size standard and limit vary in
many cases.4 Some of these preferences rely on asset size, receipt size, or
employment size to identify eligible firms. Others confer benefits on small firms not
because of some such size standard but because of the design of the provisions
themselves. (If this distinction seems confusing, the description of the principal
small business tax benefits in the following section should clarify its import.) The
lack of a uniform definition of a small firm in the tax code can lead to a firm being
eligible for some small business tax preferences but not others. It also has the
advantage of giving policymakers some flexibility in crafting tax benefits targeted at
small firms. Yet the varying size standards and limits for eligibility for small
115 U.S.C. 632(a)(1)
2Small Business Administration, Guide to SBA’s Definitions of Small Business, available at
[http://www.sba.gov/size/indexguide], visited on Feb. 26, 2004.
3Ibid.
4A recent article claims that 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.

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CRS-3
business tax preferences also create the impression that what it means to be a small
firm is an empty concept that can be recast without limit according to arbitrary
criteria.
Main Federal Tax Benefits for Small Business
In general, business income is subject to federal taxation. But not all business
income is treated equally under the federal tax code. Its taxation can differ along
numerous lines. For instance, the tax treatment of business income depends on
whether or not a firm is organized for tax purposes as a corporation. Corporate net
income is taxed twice, whereas the net income of passthrough entities such as S
corporations, sole proprietorships, limited liability companies, or partnerships is
taxed once. The taxation of business income also depends on whether or not a
corporation or the owners of passthrough entities are subject to 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 income tax.
In addition, the tax burden on business income depends on how investments are
financed. For example, the returns to corporate investments financed solely by debt
face 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.
The tax treatment of business income also differs by firm size. Various
provisions of the federal tax code confer benefits on smaller firms that are not
available or of lesser value to larger firms. The tax code makes no explicit or formal
distinction between the taxation of small and large firms in that the code does not
have separate sections for the tax treatment of small and large firms. Instead, it
contains numerous provisions scattered throughout which confer preferential
treatment on relatively small firms but not on relatively large firms. Most of these
provisions take the form of deductions, exclusions and exemptions, credits, deferrals,
and preferential tax rates. In general, tax preferences such as these have the effect of
lowering the cost of capital for new investment by small firms relative to large firms.
A few other provisions benefit small firms by reducing the cost and administrative
burden of complying with tax laws or granting tax relief in exchange for the
provision of certain fringe benefits to employees.
The 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 unclear what the net budgetary cost of subsidies with the broadest
reach is. Nevertheless, recent estimates by the Joint Committee on Taxation (JCT)
and the Treasury Department indicate that they lowered federal revenues by more
than $6.6 billion in fiscal year (FY) 2003.5
5This estimate applies to the following seven small business tax preferences only: (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 treatment of losses
(continued...)

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CRS-4
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 tax
purposes, five such forms are widely used: subchapter C corporations, subchapter
S corporations, sole proprietorships, partnerships, and limited liability companies
(LLCs).
The decision to operate in a particular organizational form has important
implications for a firm’s tax treatment. C corporation earnings are taxed twice: once
at the corporate level and again at the individual level when the earnings are
distributed to owners either as dividends or realized capital gains. By contrast, the
earnings of the other business entities are taxed only once: at the individual level of
their owners. For this reason, these entities are often referred to as passthrough
entities.6 There is no separate business-level tax on their earnings. Instead, their
profits, losses, and items of income, deduction, exclusion, and credit pass through or
are attributed to the owners according to their shares of ownership, regardless of
whether the profits have been distributed. The vast majority of businesses operate
as sole proprietorships: in 2000, they accounted for 72% of federal business tax
returns. Next in order of importance were S corporations (11% of business tax
returns), followed by C corporations (9% of returns), partnerships (5% of returns),
and LLCs (3% of returns).7
There is no legal requirement that C corporations be large in income, asset or
employment size, and that passthrough firms be small. Yet such a distinction tends
to hold in practice. In 1999, for example, the average C corporation’s asset size was
nearly three times greater than that of the average partnership and 14 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. And among the tax considerations, four are paramount: (1) the relative
5(...continued)
from sales of small business corporation stock as ordinary income; (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 2002-2006 (Washington: GPO, 2002), p. 23; and Office of
Management and Budget, Analytical Perspectives, Budget of the United States Government,
Fiscal Year 2004 (Washington: U.S. Govt. Print. Off., 2003), table 6-1, pp. 103-105.
6For more details on the taxation of non-corporate businesses, see CRS Report RL31538,
Passthrough Entities Not Taxed As Corporations, by Jack H. Taylor.
7Internal Revenue Service, Statistics of Income Bulletin: Winter 2002-2003 (Washington:
2003), pp. 165, 166, and 168.
8Internal Revenue Service, Statistics of Income Bulletin: Spring 2002 (Washington: 2002),
pp. 95, 295, and 297.

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CRS-5
tax rates for corporate income, individual ordinary income, and long-term capital
gains; (2) the investment horizon of investors; (3) the holding period for corporate
stock; and (4) the rate at which corporate profits are paid out as dividends.
Setting aside non-tax considerations, the current mix of individual and corporate
tax rates appears to favor 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 can prove this point. In 2004, 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
these investors would be better off owning a business enterprise 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 would not alter the outcome. If one assumes 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 investment is made 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 wrong to view the taxation of passthrough entities as
a small business tax benefit. This is because firm size is no obstacle to operating as
a passthrough entity: firms that are relatively large in employment, revenue, or asset
size are organized as S corporations or LLCs, and firms that are relatively small
operate as C corporations. In addition, any tax advantage presently held by small
passthrough entities could prove ephemeral, as it has in the recent past. For instance,
their present advantage would shift to corporations if legislation were enacted sharply
reducing the top corporate and long-term capital gains tax rates relative to the
maximum individual income tax rate.
9Under the recently enacted 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.
10These tax rates are derived from the following formula: (1-tp) # (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., Taxes and
Business Strategy: A Planning Approach, 2nd edition (Upper Saddle River, NJ: Prentice-
Hall, Inc., 2001), p. 67.
11The 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 is
derived from the following formula: $1[1 + R x (1- tc)]n (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.

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CRS-6
Graduated Corporate Income Tax Rates
Corporations with less than $10 million in taxable income are subject to
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 more than $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 reporting taxable income of more than $15
million up to $18.3 million pays a marginal rate of 38%. These higher marginal rates
are intended to offset the tax savings firms realize from the lower tax rates they paid
when their revenues were smaller. All corporate taxable income above $18.3 million
is taxed at a rate of 35%. As a result, the benefits of the graduated rates from 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, since their taxable incomes are likely to remain
below the $335,000 threshold. It also gives owners of closely held small firms an
incentive to incorporate in order to shield profits from higher individual tax rates.
Not all small corporations, however, are allowed to take advantage of the reduced
rates. Specifically, the taxable incomes of corporations providing services in the
fields of health care, law, engineering, architecture, accounting, actuarial science, the
performing arts, and consulting are taxed at a fixed rate of 35%, regardless of
amount. A notable drawback to a graduated rate structure is that it gives smaller
corporations a disincentive to grow beyond a certain size. In this sense, it serves as
a tax on growth.
The revenue loss arising from the reduced rates on the first $10 million of
corporate taxable income totaled an estimated $4.4 billion in FY2003.12
Expensing Allowance for Certain Depreciable Business
Assets
In essence, expensing is the treatment for tax purposes of a cost of doing
business as an ordinary and necessary expense rather than a capital expenditure.
Ordinary and necessary costs are deducted in the year in which they are incurred,
whereas capital costs typically are recovered over longer periods according to
depreciation methods and schedules specified in the federal tax code.
Under section 179 of the Internal Revenue Code (IRC), firms may expense up
to $100,000 of the cost of qualified business property – mainly machinery and
equipment and computer software – in 2003 through 2005 and write off the
12U.S. Congress, Senate Committee on the Budget, Tax Expenditures: Compendium of
Background Material on Individual Provisions, committee print, 107th Cong., 2nd sess.
(Washington: GPO, 2002), p. 267.

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CRS-7
remaining basis (if any) under current cost recovery rules.13 But because of a phase-
out rule, not all firms are able to take advantage of this allowance. The allowance is
phased out, dollar for dollar, once spending on qualified property exceeds $400,000
in a given tax year from 2003 through 2005. This means that no portion of an
investment in qualified property may expensed if the total expenditure is $500,000
or more. As a result, most of the firms able to take advantage of the allowance are
likely to be relatively small in asset size.
The allowance serves as a robust investment tax subsidy because expensing has
the effect of imposing a marginal effective tax rate of zero on the returns on
investments in qualified property. In practice, the allowance defers the income tax
on part or all of the first-year returns to investment in qualified assets. This deferral
translates into a zero marginal effective tax rate through the standard economic
model for the determination of the user cost of capital.14
In FY2003, the allowance caused an estimated revenue loss of $0.9 billion.15 In
periods of rising business investment, the allowance typically produces a revenue
loss. But when a slump in business investment follows 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. In some
cases, the entire cost of an asset is written off in its first year of use under the
expensing allowance, leaving no depreciation deductions to offset income earned by
the asset in future years.
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 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 corporate
taxable income. 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 intended to insure that all profitable
corporations pay some federal income tax.
Under the Taxpayer Relief Act of 1997 (P.L. 105-34), eligible small
corporations have been exempt from the AMT since 1998. Eligibility is determined
13For more details on the design of the expensing allowance and its economic effects, see
CRS Report RL31852, Small Business Expensing Allowance Under the Jobs and Growth
Tax Relief Reconciliation Act of 2003: Changes and Likely Economic Effects, by Gary
Guenther.
14See 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.
15Senate Budget Committee, Tax Expenditures, p. 259.

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CRS-8
by a corporation’s average annual gross receipts in the previous three tax years.
Corporations formed after 1998 are exempt from the AMT in their first tax year,
regardless 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 in which it no
longer qualifies and in every tax year thereafter.
There is some evidence that this exemption may give small corporations able
to claim it a slight competitive advantage over firms paying the AMT. A 1997 study
found that firms investing heavily in machinery and equipment and intangible assets
like research and development (R&D), financing the bulk of their investments
through debt, and paying the AMT for five or more successive years had a higher cost
of capital than comparable firms paying only the regular income tax in the same
period.16 In addition, the exemption gives owners of small firms an incentive to
incorporate, since the taxable income of owners 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 certain small firms ran into some unexpected problems in its first year
or two. According to the report, more than 2,300 small corporations paid the AMT
in 1998 when an examination of their federal income tax returns indicated that they
qualified for the exemption; their overpayments of the tax may have totaled more
than $25 million.17 The report attributed the erroneous payments to the many
complex changes made by the Taxpayer Relief Act of 1997 and the “short time”
available to taxpayers and tax professionals to comprehend these changes and take
them into consideration in filing 1998 tax returns. It recommended that the IRS take
various 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 had failed to notify more than 3,600 taxpayers who may have
mistakenly paid the AMT and fallen short of its commitment to “inform and educate
tax practitioners on what they need to do on their clients’ behalf.”18
Although it is not known of how much revenue is lost annually as a result of
exempting small corporations from the AMT, the amount is likely to be relatively
small. In 2000, corporations with assets valued at less than $100 million made about
16Andrew B. Lyon, Cracking the Code: Making Sense of the Corporate Alternative
Minimum Tax (Washington: Brookings Institution, 1997), pp. 77-97.
17Treasury 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.
18Treasury 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.

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CRS-9
$400 million in AMT payments, compared to $3.5 billion for corporations with
assets valued at $100 million and above.
Amortization of Business Start-Up Costs
One of the basic principles underlying the federal income tax is that taxable
income should exclude any costs incurred in earning it. This implies that all ordinary
and necessary costs incurred in conducting a trade or business should be deducted
from current income. The principle also suggests that costs paid or incurred before
the start of a trade or business should not be deducted from current income. Business
start-up costs generally are defined as expenditures made to acquire or create an asset
with a useful life extending beyond a single tax year. Normally, such costs should
be capitalized and 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, taxpayers who incur business start-up costs
and then enter the trade or business have the option of deducting (or amortizing)
these costs over a period of not less than five years, beginning in the month when the
business becomes active. To claim the deduction, the taxpayer must have an equity
interest in the trade or business and actively participate in its management. To
qualify for amortization, the start-up 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 or 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 costs
that would be deductible if they were paid or incurred by an existing active trade or
business in the same field entered by the taxpayer.
The option to amortize business start-up costs benefits fledgling small firms
because it permits them to deduct expenses that otherwise would not be recovered
until the taxpayer sold his or her interest in the business. In effect, it serves as a form
of accelerated depreciation for these firms, which has the benefit of encouraging the
formation and growth of new firms by reducing their cost of capital and increasing
their cash flow at a time when their access to capital may be restricted.
According to an estimate by the Joint Tax Committee, the amortization of
business start-up costs resulted in a revenue loss of $0.6 billion in FY2003.19
Cash Basis Accounting
Under IRC section 446, firms must compute their taxable income under the
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 and the expenses actually incurred. Under
19Senate Budget Committee, Tax Expenditures, p. 263.

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CRS-10
accrual-basis accounting, by contrast, 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 does
a better job of matching income with expenses. An important requirement in
selecting an accounting method for tax purposes is that it clearly reflect income.
Under current federal tax law, firms that are required to maintain inventories
must use the accrual method in computing taxable income. In addition, the following
entities generally must 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 considered a tax shelter and meet at least one of the following three criteria: (1)
is engaged in farm or tree raising, (2) is a qualified personal service corporation, or
(3) is a firm (including C corporations) with $5 million or less in average annual
gross receipts during the previous three tax years. Moreover, under recent rulings by
the IRS, 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 activity 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
under IRC section 179: the deferral of income tax payments. In principle, a firm
earns income when the legal right to be paid first 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 these firms to use it. The
reason lies in the requirements for income statements and balance sheets used in
external financial reports.20 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 leaving out transactions involving exchanges of assets or
liabilities. Second, the determination of net income under cash-basis accounting can
20See Robert Libby, Patricia A. Libby, and Daniel G. Short, Financial Accounting (Chicago:
Irwin, 1996), p. 111.

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CRS-11
be manipulated by recording revenues or expenses long before or after goods and
services are produced or sold.
The Joint Committee on Taxation estimates that the use of cash accounting
outside agriculture led to a revenue loss of $0.5 billion in FY2003.21
Tax Incentives for Private Equity Investment in Small firms
The federal tax code also contains several provisions intended to encourage the
flow of private equity capital into certain start-up small firms that might otherwise
experience considerable difficulty raising funds for current operations and new
investment. These provisions, which are described below, do so largely by increasing
potential after-tax returns or reducing 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 taxpayer’s income
tax liability are the proper 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 can arise 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
produces a capital gain. Conversely, a capital loss results when the selling price is
less than the purchase price. Capital assets that are 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 taxed at 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.22
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 located 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 given tax year, the gain is
21Senate Budget Committee, Tax Expenditures, p. 285.
22Under 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%.

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CRS-12
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, 2008.23
To qualify for the partial exclusion, small business stock must satisfy certain
requirements. First, it must have been 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 though they are devoted
largely to the development of future lines of business. Specialized small business
investment companies licensed under the Small Business Investment Act of 1958
also are deemed to meet the active business test, making their stock eligible for the
partial exclusion.
Some small firms cannot benefit from the partial exclusion. More 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, 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 a five-year period. Because of JGTRRA,
however, the investment incentive provided by the partial exclusion is much weaker
than it once was. Before JGTRRA, 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
23The 7% rate stems from a provision in JGTRRA.

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CRS-13
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%. JGTRRA unified
and lowered the maximum tax rate on long-term capital gains to 15% but made no
change in the taxation of capital gains on QSBS.
An estimated $130 million in revenue was not collected in FY2003 because of
the exclusion.24
Losses on Small Business Investment Company Stock Treated as
Ordinary Losses.
Generally, losses on stock investments are treated as capital losses. 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 in a
single tax year all losses from the sale or exchange or worthlessness of stock in these
companies. This provision encourages private 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 in business stock. 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
direction to firms with less than $18 million in assets and less than $6 million in net
income in the previous two years. They use their own capital and funds borrowed
with a SBA guarantee to make equity and debt investments in qualified firms. In
FY2002, SBICs provided $2.5 billion in financing for 2,610 firms.25
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 year when they are realized.
But under IRC section 1044, which was adopted as part of the Omnibus Budget
Reconciliation Act of 1993, individual and corporate taxpayers who satisfy certain
conditions are allowed to roll over without the payment 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
24U.S. Office of Management and Budget, Budget of the United States Government, Fiscal
Year 2005: Analytical Perspectives (Washington: GPO, 2004), table 18-1, p. 287.
25See the Web site for the U.S. Small Business Administration’s SBIC program:
[http://www.sba.gov/INV].

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CRS-14
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 reduced by gains
previously rolled over under this provision. For corporations, the maximum deferral
is $250,000 or $1 million reduced by previously deferred gains.
Losses on Small Business Stock Treated as Ordinary Losses.
IRC section 1244 permits individuals to deduct any loss from the sale or
exchange or worthlessness of stock issued by a small business corporation as an
ordinary rather than a capital loss. A firm must satisfy two requirements in order to
qualify as a small business corporation: (1) the total amount of money and property
received by the firm as a contribution to capital and paid-in surplus cannot exceed $1
million when the stock is issued, and (2) during the five tax years preceding the year
in which the loss on the stock is realized, 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 may be
deducted as an ordinary loss in a tax year is $50,000 ($100,000 for a couple filing
jointly).
This special treatment led to an estimated revenue loss of $40 million in
FY2003.26
Uniform Capitalization of Inventory Costs
Firms deriving income from the production, purchase, or sale of merchandise
must 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 taxable
income. The cost of goods sold generally 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 sum 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, known as the uniform capitalization rule, was
added to the tax code by the Tax Reform Act of 1986. In general, direct costs are the
material and labor costs associated with the production or acquisition of goods, and
indirect costs are all other costs associated with 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,
26Budget of the U.S. Government in Fiscal Year 2005: Analytical Perspectives, table 18-1,
p. 287.

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CRS-15
provided the methods used in the allocation produce reasonable 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 taxpayer
with average annual gross receipts of $10 million or less in the previous three tax
years. This exemption is advantageous in that 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
Simplified Dollar-Value LIFO
Accounting Method for Small Firms
Business taxpayers that maintain inventories in order to determine the cost of
goods sold in a tax year must measure the value of their inventories at the beginning
and end of each tax year. Because it is difficult 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 unit costs of many
inventory items are rising because LIFO yields a lower taxable income and lower
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 of dollars includes the value of a number of different 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 is complicated and costly for most taxpayers.28
But under IRC section 474, which was established by the Tax Reform Act of
1986, some small firms may use a simplified dollar-value LIFO method. It differs
from the regular dollar-value method in the manner in which inventory items are
pooled and 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.
27See Paul G. Schloemer, “Simplifying the Uniform Inventory Capitalization Rules,” Tax
Notes, vol. 53, no. 9, Dec. 2, 1991, pp. 1065-1069.
28For 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, April 23,
1996), pp. 18-19.

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Tax Credit for Pension Plan Start-Up Costs of Small Firms
Under IRC section 45E, certain 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 the 2002 tax year and is scheduled
to disappear (or “sunset”) after 2010. It is part 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 ordinary and necessary expenses related to the 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. In order to do so, however, at
least one highly compensated employee of eligible firms must participate in the plan.
The credit is intended to give owners of small firms that never have offered
retirement benefits 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 suggested that these costs often constitute a formidable
barrier to the creation of these plans among small employers. An estimated $20
million in revenues was not collected in FY 2003 because of the credit.29
Magnitude of Small Business Tax Benefits
This description of the principal small business tax preferences makes clear that
the federal tax code favors the formation of small firms and fosters their growth in
a variety of ways. It also raises the question of to what extent the tax code generally
favors smaller firms over larger ones. While it is very difficult to come up with a
cogent answer that embraces all small business tax preferences, one can shed light
on the magnitude of these preferences by assessing the effects of certain ones.
Consider the expensing allowance under IRC section 179. In the minds of
many, the allowance is the quintessential small business tax subsidy, 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, presently the director of the Congressional
Budget Office, analyzed the effect of the expensing allowance on a firm’s user cost
of capital. As was discussed earlier, expensing stimulates business investment by
reducing the contribution of income taxes to the user cost of capital. Table 1
summarizes his findings.30 The first column gives the assumed corporate tax rate; the
29Ibid., table 6-1, p. 105.
30Douglas Holtz-Eakin, “Should Small Businesses Be Tax-Favored?,” Tax Notes, vol. 48,
(continued...)

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CRS-17
second shows the required pre-tax rate of return if the entire cost of the investment
were expensed; the third provides the required pre-tax rate of return if the entire cost
were recovered through the depreciation allowances allowed under current tax law;
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 inferences can be extracted from the
results. First, expensing produced a significant investment subsidy, and the extent
of the subsidy rose with 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%,
expensing lowered the user cost of capital by 28%. Second, the user cost of capital
under expensing fell as the tax rate increased because tax deductions become
increasingly valuable at higher tax rates.
Table 1. Estimated User Cost of Capital Under Expensing
(%)
Corporate Tax
Regular
Expensing
Size of Subsidy
Rate
Depreciation
15
17.95
20.23
2.28
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.
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: c/q = (p-
B+d/1-t) x (1-tz), 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, B 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 indicate that small firms make significant contributions to the
performance of the U.S. economy.31 The vast majority of employers are small firms,
which are defined as independent business enterprises with fewer than 500
employees. They account for more than 50% of employment and over 44% of the
30(...continued)
No. 3, Sept. 1995, p. 389. (In 2003, Dr. Holtz-Eakin was named the Director of the
Congressional Budget Office.)
31 The primary source for source data is the Small Business Administration (SBA). A
useful publication is Small Business by the Numbers, which is issued by the SBA’s Office
of Advocacy. It was last updated in May 2003 and is available from the SBA website at
[http://www.sba.gov/advo/stats/sbfaq].

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payroll in the domestic private sector. In addition, throughout the 1990s, small firms
were responsible for 60% to 80% of annual net new job creation and generated over
50% of non-farm private gross domestic product. Most firms start out as small in
employment size, but their chances of eventually growing into large, competitive,
established firms are less than substantial. About one in every two new firms
survives at least four years.32 Each year, hundreds of thousands of new firms come
into existence, and hundreds of thousands existing firms cease to exist. This constant
churning is reflected in the shifting contributions of small firms to annual net job
creation.
Small firms also appear to play important roles in industries where technological
innovation is a central driving force for growth and change. They employ nearly four
out of every 10 scientists, engineers, and computer specialists working in the private
sector, and small firms that file claims for patents produce 13 times as many patents
per employee as large firms that do likewise.
Economic Arguments For and Against Small
Business Tax Subsidies
Existing small business tax subsidies and proposals to expand them raise some
intriguing and important policy issues. For specialists in public finance, a key issue
is whether or not such subsidies can be justified on economic grounds. Can a sound
argument embedded in the principles of economic equity or efficiency be made in
favor of small business tax subsidies? The answer has important implications for
social welfare, since more than $6 billion in tax subsidies are given annually to small
firms, in addition to federal programs designed to lend financial support to small
business. If the economic rationale for these tax subsidies proves weak or untenable
upon careful examination, then it could be argued that channeling these resources
into other applications (e.g., reducing the federal budget deficit or raising federal
spending on public education) may produce more desirable economic outcomes. At
the same time, it should be recognized that small business tax subsidies have been
justified on certain non-economic grounds, and that these arguments can and do
outweigh purely economic considerations in the minds of some policymakers
evaluating proposals to expand the subsidies.
Nevertheless, the central focus of this section is the economic arguments for and
against such proposals and their merits. These arguments are explored below.
Chief Economic Arguments in Favor of the Subsidies
In general, proponents of small business tax subsidies cite three economic
justifications for them: (1) the special economic role played by small firms; (2) the
barriers to their formation and growth in financial markets; and (3) the opportunities
for individual economic advancement offered by small business ownership.
32Small Business Administration, Small Business by the Numbers.

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The direct economic contributions of small firms are often cited as reasons to
back proposals in Congress to increase federal support for small business. For
example, in the 107th Congress, Senator Christopher Bond noted on the floor of the
Senate 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.”33 Similarly, Senator Olympia Snowe stated on the floor of
the Senate early in the first session of the current Congress, in introducing legislation
to expand the small business expensing allowance, that “they (small businesses)
represent 99% of all employers, employ 51% of the 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.”34
But proponents of small business tax subsidies also look beyond the direct and
immediate economic impact of small firms to find justification for them. In
particular, they cite the increases in economic efficiency produced by small firms, the
dynamic changes in economic structure and important technological innovations
generated by small entrepreneurial firms, the valuable opportunities for social and
economic advancement created by small firms for minorities, women, and
immigrants, and the difficulties faced by promising small start-up firms in raising
capital.
In defending small business tax subsidies, some point to evidence that small
firms can supply certain goods and services more efficiently than large firms. As
economist Bo Carlsson has noted, this advantage can be found in industries
characterized by large production runs and falling unit costs such as automobiles and
steel.35 In industries such as these, small and large firms specialize in different
products or services and often end up interacting more as collaborators than
competitors. In Carlsson’s view, the rise in outsourcing among large U.S. firms in
the 1990s served to further solidify this division in labor between large and small
firms. Among the reputed advantages of small firms in the vast 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 growth appears rooted in the critical roles played by small start-up firms
in the growth of certain high-technology industries going back to the 1950s. Two
notable findings in the recent literature on firm size and technological innovation is
that 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
33Sen. Christopher Bond, remarks in the Senate, Congressional Record, daily edition, vol.
147, Jan. 25, 2001, p. S576.
34Sen. Olympia Snowe, remarks in the Senate, Congressional Record, daily edition, vol. 149,
no. 6, Jan. 14, 2003, p. S299.
35Bo 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.

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relatively low levels of concentration.36 The same literature offers fresh evidence that
in certain industries small start-up firms are more adept than large established firms
at identifying promising applications for new technologies and exploiting these
opportunities. During the 1980s and 1990s, several dramatic illustrations of this
adeptness emerged in biotechnology, microelectronics, computer software, and
electronic commerce.37
Experiences such as these have led some economists to conclude that small
entrepreneurial firms 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.”38
Proponents of small business tax subsidies also cite the many benefits of small
business ownership for women, minority groups, immigrants, and the communities
where they reside as an important economic 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, they 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 in general encourage greater openness
in workplace communication and decision-making and are more likely to hire a
diverse workforce, put into place desirable child-care programs, and pay full benefits
to employees than male small business owners, and that families with self-employed
women who work out of their homes are more stable than the average family.39 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 markets.40
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
entrepreneurs in raising funds to start a business or to expand one. If capital markets
were truly efficient, then every small business investment opportunity offering a rate
of return above the cost of capital would obtain funding, regardless of the
creditworthiness of the owners. But proponents of small business tax subsidies say
36Joshua Lerner, “Small Business, Innovation, and Public Policy,” in Are Small Firms
Important? Their Role and Impact, p. 160.
37Ibid., p. 160.
38Bo Carlsson, “Small Business, Entrepreneurship, and Industrial Dynamics,” p. 109.
39See 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.
40See 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.

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CRS-21
that such is not the case. They argue that largely because of inadequate information
on the part of investors, many potential and current entrepreneurs are unable to
borrow or attract equity capital, compelling them to finance projects out of their own
resources and those of friends and family members or abandon them altogether.
Small business owners facing severe liquidity constraints have an elevated risk of
failure.
Chief Economic Arguments Against the Subsidies
While acknowledging the significant economic role played by small firms, some
maintain that this role should not be construed as a sound justification for targeting
tax subsidies at small firms. Among public finance economists, a standard rationale
for government intervention in the economy is the presence of some kind of market
failure. In general, market failures are conditions that prevent or 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.41 Critics of small business tax subsidies say
there is no evidence that a market failure hinders the formation or growth of small
firms. Moreover, in their view, such subsidies are likely to produce undesirable
equity and efficiency effects.
Equity Concerns.
Critics charge that the main equity effect of small business tax preferences is to
undercut the progressivity of the federal individual income tax. Under a progressive
income tax, a taxpayer’s tax liability depends on his or her taxable income, and
taxpayers with higher taxable incomes pay more in tax 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 small business owners. It is
thought that individuals, and not firms, ultimately bear the burden of business income
taxes. While all owners of capital stand to benefit ultimately from small business tax
preferences, a large portion of those benefits probably end up in the hands of small
business owners, whose income and wealth tend to be well above average for U.S.
households.42
41For 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.
42According 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, George W. Haynes found that, in 1998, the mean income of households
with small business owners was $101,563, compared to $43,999 for households with no
business owners, and the mean wealth of households with small business owners was
$832,514, compared to $171,904 for households with no business owners. (See George W.
Haynes, Wealth and Income: How Did Small Businesses Fare from 1989 to 1998?, Small
(continued...)

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CRS-22
Efficiency Concerns.
Critics also criticize small business tax subsidies on efficiency grounds. In
theory, income taxes reduce social welfare by causing distortions on consumer
behavior. As a result, those taxes are likely to cause the least economic damage
when the tax code does not prevent economic resources from migrating to their most
productive uses. This doctrine of neutrality has certain important implications for tax
policy. First, it implies that the returns to all investments should be taxed at uniform
rates. Second, the doctrine implies that any tax on a factor of production or output
that is not uniform across firms may harm social welfare.43 Finally, it implies that
taxes should not distort a firm’s choice of inputs or its investment or production
decisions. Critics of small business tax preferences contend that they violate each of
these policy prescriptions. In their view, an efficient or optimal 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.44

Critics also deny that there is something uniquely desirable about the economic
role of small firms that would warrant the use of tax subsidies (or other government
subsidies, for that matter) targeted at small firms. Backers of small business tax
preferences have argued that these firms are demonstrably and consistently superior
to large firms in creating jobs and hatching important technological innovations, and
that these talents are a sufficient economic justification for the preferences. But
critics question these claims and point out that the direct economic contributions of
small firms would appear to refute any argument for government subsidies targeted
at such firms.

Critics and proponents alike agree that small firms generally are a fecund 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.45 But critics
maintain that for a variety of reasons these data do not necessarily prove that small
firms are endowed with a greater job-creating prowess than large firms. To begin
with, they note that the data raise more questions than they answer. Among the key
unanswered questions: 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?
42(...continued)
Business Administration (Washington: May 16, 2001), pp. 24 and 27.
43Stiglitz, Economics of the Public Sector, pp. 567-569.
44Douglas Holtz-Eakin, “Should Small Businesses be Tax-Favored?,” National Tax Journal,
vol. 48, no. 3, Sept. 1995, p. 390.
45U.S. Small Business Administration, Office of Advocacy, Small Business FAQ,
(Washington: Dec. 2000).

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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.46
Second, most jobs created by small firms are created by new firms, which typically
start out small in employment or asset size; and many of these jobs do not last a long
time because most new firms fail within their first few years.47 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 went
swiftly from small to large, and in some cases from large back to small, suggesting
that their job-creating ability was unstable at best.48 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.49
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 over time. Economic analysis
indicates that the economy generates jobs through the natural processes of growth,
decline, and structural change, regardless of the size distribution of firms. From this
perspective, the level of national employment results from a mix of factors that
would swamp the employment effects of any small business subsidies. The key
factors are fiscal and monetary policy, overall consumption and 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 an engine of long-term economic growth. Economists
generally agree that without government support, private 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 exploit 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
46See 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
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%.
47Ibid., p. 8.
48Birch and Medoff, “Gazelles,” pp. 162-164.
49Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction
(Cambridge, MA: MIT Press, 1996), pp. 169-170.

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CRS-24
unwilling or unable to provide investors with the information they require to evaluate
the potential returns on planned R&D investments.50 This tendency to invest too
little in R&D represents a market failure in that too few resources are allocated to
R&D compared to its potential economic benefits. To remedy this failure, many
economists advocate government support to encourage private-sector R&D
investment.
But critics of small business tax subsidies maintain that it is far from clear that
this support should be targeted at small firms. They point to a wealth of evidence
suggesting that both small and large firms hatch the innovations that end up driving
the processes of economic growth and structural change, and that it is impossible to
disentangle the contributions of each group. According to data reported by the
National Science Foundation (NSF), larger firms perform the vast share of business
R&D: from 1992 to 1997, 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 this spending.51 Nonetheless, small firms
and large firms each appear to have distinctive advantages as agents of technological
innovation.52 In addition, numerous studies have been done of the effects of firm size
and market structure on innovation.53 On the whole, they suggest that no firm size
has proven to be ideal for generating new and successful commercial technologies.
Another finding was that in some industries, small firms were more innovative, but
in other industries, large firms had the edge.
Other Concerns.
Critics also raise questions about the suitability and effectiveness of some
current or proposed small business tax subsidies.
One argument in favor of these subsidies is that a steady creation of new small
firms is needed to prevent the development of monopoly power by large firms. But
critics claim that it is far from clear that the best way to achieve such a policy goal
is to offer government support for the formation and growth of small firms. They
50Scott 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.
51National Science Board, Science & Engineering Indicators – 2000, Vol. 1 (Arlington, VA:
2000), appendix table 2-54, pp. A-97 and A-98.
52On 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.
53F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance,
3rd edition (Boston: Houghton Mifflin Co., 1990), pp. 651-657.

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CRS-25
point out that only a tiny share of small start-up firms survive and grow to the point
where they pose a serious competitive threat to large entrenched firms in the same
market. In their view, antitrust law is likely to be a more effective tool than small
business tax subsidies for thwarting the rise of monopoly power and other anti-
competitive business practices.
Similarly, as has been noted, proponents of small business tax subsidies claim
that small firms create a disproportionate share of new jobs. But critics respond 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, such as the
current expensing allowance. Such subsidies have the effect of lowering the cost of
capital relative to labor, thereby encouraging small firms to substitute machinery and
equipment for labor.
Furthermore, critics argue that small business tax subsidies impose an implicit
or a hidden tax on business growth. This tax has been described as the “notch
problem,” and it is an unavoidable byproduct of the design of many tax preferences
targeted at small firms. Under the typical small business tax subsidy, firms lose the
tax benefit when their employment, assets, or receipts surpass a certain limit
specified by law. Such a design can create a disincentive to grow beyond that limit.
The expensing allowance under IRC section 179 illustrates this pitfall. As a firm
raises its investment in assets that qualify for the allowance beyond $400,000, the
amount that may be expensed is reduced dollar for dollar, ultimately to zero starting
at $500,000. In effect, this rule gives 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
estimates that the marginal effective tax rate on investment in equipment is 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 $500,000.54 Douglas Holtz-
Eakin has pointed out that this phase-out rule effectively raises a firm’s cost of
capital at a time when its growth is boosting its capital needs.55
54The 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.
55Holtz-Eakin, “Should Small Businesses Be Tax-Favored?,” p. 393.

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Conclusions
There is no question that small firms make important contributions to the
performance and growth of the U.S. economy. Available evidence indicates that,
depending on how small firms are defined, they account for a majority of private-
sector jobs and private-sector output, generate many technological innovations, and
serve as agents of renewal and structural change in a variety of industries.
These contributions explain much of the widespread support inside and outside
of Congress for government policies to assist small business. A concrete
manifestation of this support 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, probably exceeded $6.6 billion
in FY2003. A variety of initiatives to expand these subsidies are attracting bipartisan
support in the 108th Congress.
Mainstream economic analysis suggests that it is difficult to justify an expansion
of small business tax subsidies on economic equity or efficiency grounds. Small
business tax preferences reduce the tax burden on owners of small firms, somewhat
diluting the progressivity of the federal individual income tax system. In addition,
under current market conditions, it appears that there would be no clear efficiency
gains from further subsidizing small firms through the tax code. Economic theory
holds that the efficiency losses 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. And what is known about the economic contributions and
performance of small firms does not appear to support the view that their formation
and growth are hindered by market failures that would warrant targeted government
support.
This is not to imply, however, that government support for small firms would
never be justified on economic grounds. There is plenty of empirical evidence that
small entrepreneurial firms play critical roles in production and economic growth and
structural change. Measures aimed at simplifying tax accounting and compliance for
small firms would have desirable efficiency effects. In addition, the emergence of
a market failure that hampers the formation and growth of small firms would
establish a sound economic rationale for government intervention. A possibility
would be capital market imperfections that systematically impede the entry of new
small entrepreneurial firms or greatly diminish their chances of survival. Such a
market failure could be eliminated or ameliorated through policy measures that
increase the supply of capital to small start-up firms without substantially distorting
the allocation of capital in the economy at large. Tax subsidies might be one such
measure, but to be effective, they would need to address the root causes of any 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 also 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 debate on this issue.

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Holtz-Eakin has noted that the use of such a model would enable policymakers to
determine whether any market failures are hampering the formation and growth of
small firms, identify the factors underlying these failures, and devise policies
intended to address these factors.56
56Ibid., p. 393.

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