Small Business Tax Relief: Proposals in the 108th Congress and Their Economic Justification

Small Business Tax Relief: Proposals in the 108th Congress and Their Economic Justification

Order Code RL31052
Report for Congress
Received through the CRS Web
Small Business Tax Relief: Proposals in the 108th
Congress and Their Economic Justification
Updated May 9, 2003
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Small Business Tax Relief: Proposals in the 108th
Congress and Their Economic Justification
Summary
Congress has a perennial interest in the federal tax burden on small firms and
its effect on their performance and growth. This concern lies behind the initiatives
being considered in the 108th Congress to expand current small business tax
preferences or create new ones. So far, 19 such bills have been introduced: H.R. 2
(as approved by the Ways and Means Committee on May 7, 2003), H.R. 22, H.R.
179, H.R. 224, H.R. 450, H.R. 714, H.R. 1079, H.R. 1126, H.R. 1222, S. 2 (as
approved by the Senate Finance Committee on May 8, 2003), S. 53, S. 86, S. 106, S.
158, S. 414, S. 513, S. 842, S. 850, and S. 906.
While the federal revenue cost of existing preferences is not known, estimates
by the Joint Committee on Taxation suggest that it exceeds $5 billion in fiscal year
2003. The small business tax preferences 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.
Proposals to expand small business tax preferences or subsidies raise several
interesting and important policy issues. For public finance economists, a key issue
is whether or not they can be justified on economic grounds. They argue that in the
absence of such a rationale, such proposals may adversely affect efficiency and
equity.
In general, proponents of small business tax subsidies cite the special economic
role played by small firms and the barriers to their formation and growth as the main
economic justifications for such subsidies. More specifically, they assert that there
are compelling economic reasons to favor small firms through the tax code: namely,
the national 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 output and employment, critics of small business tax subsidies argue that
there appears to be no sound economic rationale for doing so. More specifically, they
note that these subsidies lessen the progressivity of the federal individual income tax
and appear to produce net efficiency losses. Moreover, critics assert that regardless
of their economic rationale, some current tax subsidies are either inappropriate or
poorly designed.
The discussion presented here underscores the need for the development of a
robust economic model of the formation of small firms and their contributions to the
performance and growth of the economy over time. The report will be updated to
reflect significant legislative activity.

Contents
Current Federal Tax Benefits for Small Business . . . . . . . . . . . . . . . . . . . . . . . . . 1
Taxation of Passthrough Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Graduated Corporate Income Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Expensing Allowance for Certain Depreciable Business Assets . . . . . . . . . . 5
Exemption of Certain Small Corporations From the Corporate
Alternative Minimum Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Amortization of Business Start-Up Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Cash Basis Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Exclusion of Gains on Certain Small Business Stock . . . . . . . . . . . . . . . . . . 8
Tax Credit for Pension Plan Start-Up Costs of Small Firms . . . . . . . . . . . . . 8
Magnitude of Small Business Tax Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Legislative Initiatives in the 108th Congress to Enhance or Expand
Current Small Business Tax Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
IRC Section 179 Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Exclusion of Gains on Certain Small Business Stock . . . . . . . . . . . . . . . . . 12
Expanded Eligibility for S Corporation Status . . . . . . . . . . . . . . . . . . . . . . 12
Tax Credit for Small Firms Offering Health Insurance to Employees . . . . 12
Special Amortization Deduction for Intangible Assets Acquired
from Certain Small Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Economic Arguments For and Against Small Business Tax Subsidies . . . . . . . . 13
Chief Economic Arguments in Favor of the Subsidies . . . . . . . . . . . . . . . . 14
Chief Economic Arguments Against the Subsidies . . . . . . . . . . . . . . . . . . . 16
Equity Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Efficiency Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Other Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
List of Tables
Table 1. Estimated User Cost of Capital Calculations Under Expensing (%) . . . 9

Small Business Tax Relief:
Proposals in the 108th Congress and
Their Economic Justification
Some policy issues receive continuing attention from Congress. One such issue
is the federal tax burden of small firms and its effects on their performance and
growth. In the 108th Congress, a variety of bills have been introduced to lessen this
burden, either by enhancing current small business tax preferences, creating new
ones, or simplifying tax administration and compliance for small firms. While some
of the proposals are attracting widespread bipartisan support, their prospects for
passage have become entangled with mounting concern in Congress over the re-
emergence of a sizable and growing federal budget deficit and the deteriorating
outlook for the federal budget in the next few years.
In general, proposals to expand small business tax subsidies raise some
important economic policy issues. These issues carry significance for policymakers
because substantial resources are transferred to small firms through such subsidies.
Among public finance economists, a key issue is whether they can be justified on
economic grounds. If such a rationale cannot be found or is deemed tenuous at best,
they assert, measures to expand small business tax preferences may end up inflicting
harm on economic performance in the long run or fostering undesirable shifts in the
distribution of the federal tax burden among income classes.
This report explores this issue by examining the economic arguments for and
against small business tax subsidies in the context of current congressional proposals
to expand them. It begins with a brief description of current federal tax subsidies for
small firms, moves on to consider the principal economic arguments for and against
these subsidies, and concludes with a discussion of proposals in the 108th Congress
to expand small business tax subsidies and their likely economic effects. It will be
updated to reflect important legislative activity.
Current Federal Tax Benefits for Small Business
The federal tax code makes no explicit or formal distinction between the
taxation of small and large firms. There are no separate sections in the code 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.1 Most of these provisions take the form of deductions,
1 See CRS Report RL30827, Federal Tax Benefits for Small Businesses: A Brief Overview,
(continued...)

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exclusions and exemptions, credits, deferrals, and preferential tax rates. Tax
preferences such as these have the effect of lowering the marginal effective tax rate
on the returns to new investment for 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 tying tax relief to the offering of certain fringe benefits
to employees.
There is no uniform definition of “small business” or “small firm” in the federal
tax code — or, for that matter, in the many federal data series on the economic
condition and role of small firms. The result is a lack of consistency in defining the
firms eligible for small business tax benefits. For instance, some small business tax
preferences may be claimed by firms with annual gross receipts below a certain size
(e.g., $7.5 million), while others are crafted to apply only to firms below a certain
asset size (e.g., $25 million). Employment size is rarely used as a criterion for
determining which firms are eligible for these preferences. By contrast, the Small
Business Administration (SBA) relies heavily on employment size to classify firms
for the data it collects and publishes on the economic condition of small business.
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. While it is unclear what the exact total budgetary cost of these subsidies
is, recent estimates by the Joint Committee on Taxation (JCT) and the Treasury
Department indicate that it probably exceeded $5.0 billion in fiscal year (FY) 2003.2
Taxation of Passthrough Entities
Business enterprises operate in a variety of legal organizational forms. For tax
purposes, five forms are widely used: subchapter C corporations, subchapter S
corporations, sole proprietorships, partnerships, and limited liability companies
(LLCs). These distinctions relate to the analysis of small business tax preferences
because of important differences in their tax treatment. 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 owners (i.e., shareholders) 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. The vast majority of
businesses operate as sole proprietorships: in 1999, they accounted for 72% of
federal business tax returns. Next in importance were S corporations (11% of
1 (...continued)
by Gary Guenther.
2 This estimate applies to the following four 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; and (4) the treatment of
losses from sales of small business corporation stock as ordinary income. See U.S.
Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal
Years 2002-2006 (Washington: GPO, 2002), p. 23.

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business tax returns in 1999), followed by C corporations (9% of returns),
partnerships (5% of returns), and LLCs (2% of returns).
There is no legal requirement that corporations be large in income, asset or
employment size and that passthrough firms be small. Yet such a distinction seems
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.3
Whether a business owner would be better off operating as a C corporation or
as a passthrough entity can be a complicated question. The answer depends on a host
of tax and non-tax considerations. Among the tax considerations, a few stand out:
the relative tax rates for corporate and personal income and capital gains, the
investment horizon of owners, the holding period for corporate stock, and the rate at
which corporate profits are paid out as dividends.
For investors in the upper tax brackets, the current mix of individual and
corporate tax rates appears to favor passthrough entities by a small margin. A few
simple calculations illustrate this point. In 2003, the top personal tax rate is 38.6%;
most corporate profits are taxed at 35%; and the top tax rate on long-term capital
gains is 20%.4 Given an investment horizon of one year, tax considerations alone
dictate that these investors would be better off investing in a business enterprise
operated as a partnership rather than a corporation. Under such a scenario, pre-tax
returns to a partnership would be taxed at a marginal tax rate of 38.6%, whereas the
pre-tax returns to a corporation would be taxed at marginal rate of 48%.5 Extending
the investment horizon to five years does not alter the outcome. Assuming all after-
tax income earned during that period is reinvested in the business, and individuals
in the top tax bracket could earn average annual pre-tax rates of return of 20% on the
same investment in both partnerships and corporations, partnerships would earn a
higher after-tax rate of return than corporations: 12.2% versus 10.8%.6
3 Internal Revenue Service, Statistics of Income Bulletin: Spring 2002 (Washington: 2002),
pp. 95, 295, and 297.
4 As a result of the recently enacted Economic Growth and Tax Relief Reconciliation Act
of 2001 (P.L. 107-16), the top individual income tax rate dropped from 39.6% to 38.6% on
July 1, 2001 and is scheduled to remain at that level through the end of 2003.
5 These 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.
6 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. 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 Myron S. Scholes, Taxes and Business Strategy. p.
66.

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Nonetheless, these tax advantages do not mean that the taxation of passthrough
entities should be considered a small business tax benefit. Firms that are relatively
large in employment, revenue, or asset size operate as S corporations or LLCs, and
firms that are relatively small in these attributes are organized as C corporations. In
addition, any tax advantage held by passthrough entities could prove ephemeral, as
it has in the recent past. For instance, their present advantage would vanish if
legislation were enacted sharply reducing 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
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 of over $10 million up 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 5 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 benefits firms reap from the lower tax rates they paid when their
revenues were smaller. All corporate taxable income above $18.3 million is taxed
at a flat 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 largely benefits corporations that are 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 shelter 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 flat rate of 35%, regardless of amount.
One significant drawback to a graduated rate structure is that it gives smaller
corporations a disincentive to grow beyond a certain size; indeed, it could be
considered a tax on growth.
The revenue loss associated with the reduced rates on the first $10 million of
corporate taxable income totaled an estimated $4.4 billion in FY 2003.7
7 U.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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Expensing Allowance for Certain Depreciable Business
Assets
In essence, expensing is the treatment for tax purposes of a business cost 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 at allowable depreciation rates.
Under section 179 of the Internal Revenue Code (IRC), firms may expense up
to $25,000 of the cost of qualified business property — mainly equipment — in 2003
and succeeding years and depreciate the remainder (if any) under current cost
recovery rules. 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 $200,000 in a given tax year. This means
that in 2003, no portion of an investment in qualified property may expensed if the
total cost is $225,000 or more. As a result, most of the firms able to take advantage
of the allowance are relatively small in asset, employment, or revenue size.
The allowance can be regarded as an influential tax subsidy for business
investment because expensing effectively taxes the returns on investments in
qualified property at a marginal effective rate of zero. In practice, the allowance has
the effect of deferring income tax on a portion of the first-year returns to investment
in depreciable assets that are expensed. This deferral translates into the zero
marginal effective tax rate through the standard economic model for the
determination of the user cost of capital.8
In FY 2003, the allowance resulted in an estimated revenue gain of $0.7 billion.9
In periods of rising business investment, the allowance typically contributes to a
revenue loss. However, when a slump in business investment follows a period of
sustained growth, the allowance can lead to a net revenue gain. This is because of
the timing of depreciation deductions under expensing.
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.
Since 1998, corporations with average annual gross receipts of $5 million or less
in the three previous tax years have been exempt from the AMT. Some believe that
this exemption may give some small corporations a slight advantage over larger
8 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.
9 Senate Budget Committee, Tax Expenditures, p. 259.

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competitors who pay 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.10 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.
It is not known how much revenue is lost as a result of exempting small
corporations from the AMT.
Amortization of Business Start-Up Costs
Normally, costs paid or incurred before the start of a trade or business are not
deductible, whereas ordinary and necessary costs incurred in conducting a trade or
business are deductible under IRC section 162. Business start-up costs are
considered expenditures made to acquire or create an asset with a useful life
extending beyond a single tax year and thus should be capitalized and added to the
taxpayer’s basis in the business. They normally are recovered upon the sale or
cessation of the business.
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 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 the start-up of a trade or business, or any activity done to produce
income or profit in advance of starting a trade or business but in anticipation of
becoming an active trade or business. Second, the costs must be costs that would be
deductible if they were paid or incurred as part of an existing active trade or business
in the same commercial activity 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, and it encourages 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 very restricted.
According to an estimate by the Joint Tax Committee, the amortization of
business start-up costs led to a revenue loss of $0.6 billion in FY 2003.11
10 Andrew B. Lyon, Cracking the Code: Making Sense of the Corporate Alternative
Minimum Tax (Washington: Brookings Institution, 1997), pp. 77-97.
11 Senate Budget Committee, Tax Expenditures, p. 263.

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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
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 adhering to the requirements of accrual-basis accounting records income when
its right to receive it is established, and expenses when the amounts are fixed and its
responsibility to pay is established. On the whole, cash-basis accounting is much
simpler to administer, but accrual-basis accounting tends to yield a more accurate
measure of a firm’s economic income because of mismatches between the timing of
income and expenses. Whichever accounting method is used for tax purposes must
clearly reflect income.
Current federal tax law requires certain firms to use the accrual method in
computing taxable income: namely, firms required to maintain inventories, C
corporations with average annual gross receipts above $5 million in the last three tax
years, partnerships with C corporations as partners, trusts that earn unrelated business
income, and authorized tax shelters.
The cash method may be used if a firm is not a tax shelter and meets 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, firms in the following two categories may
use the cash method: (1) most sole proprietorships, S corporations, and partnerships
with average annual gross receipts of $1 million or less in the three previous tax
years, and (2) 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 but that provide some merchandise along with
these activities. As these rules suggest, many of the firms using the cash method for
tax purposes are small in income, asset, or employment size.
Cash-basis accounting can confer the same tax benefit on small firms as the
section 179 expensing allowance: the deferral of income tax payments. In principle,
a firm earns income when the legal obligation 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.

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The Joint Committee on Taxation estimates that the use of cash accounting
outside agriculture cost the U.S. Treasury $0.5 billion in forgone tax revenue in FY
2003.12
Exclusion of Gains on Certain Small Business Stock
Under IRC section 1202, long-term capital gains on the sale or exchange of
certain small business stock are taxed at a preferential rate. Provided all the
requirements are satisfied, this rate is 14%. By contrast, the maximum long-term
capital gains tax rate on the sale or exchange of stock held longer than one year is
20%; it drops to 18% if the stock is held more than five years. The preferential rate
for small business stock results from excluding 50% of the gain from taxation and
taxing the remainder at a maximum rate of 28%. For individuals subject to the AMT,
42% 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.
To qualify for the exclusion, the stock must be held more than five years, must
have been issued after August 10, 1993 by a C corporation that has gross assets
valued at $50 million or less when the stock was issued and uses 80% or more of its
assets in the active conduct of a trade or business (with some exceptions), and must
have been acquired by individual taxpayers at its original issue in exchange for
money or property or as payment for services rendered to the issuing corporation.
The capital gain eligible for the exclusion is limited to the greater of $10 million or
10 times the taxpayer’s basis in the stock..
The exclusion benefits some small firms because it gives investors a tax
incentive to purchase and hold the stocks of eligible small firms which otherwise may
be unable to raise equity capital.
An estimated $130 million in revenue was forgone in FY 2003 because of the
exclusion.13
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 some of the start-up costs involved in setting up new retirement plans for
employees. The credit was enacted as part of the Economic Growth and Tax Relief
Reconciliation Act of 2001 and, like many of its provisions, is scheduled to disappear
(or “sunset”) after 2010. It 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. Firms with fewer than 100 employees who received at least
12 Senate Budget Committee, Tax Expenditures, p. 285.
13 U.S. Office of Management and Budget, Budget of the United States Government, Fiscal
Year 2004: Analytical Perspectives (Washington: GPO, 2003), table 6-1, p. 103.

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$5,000 in compensation in the previous year are eligible to claim the credit; but in
order to do so, at least one highly compensated employee must participate in the plan.
The credit is intended to give owners of small firms that never have offered
retirement benefits an 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 suggest that these costs constitute a formidable barrier to the creation
of these plans among small employers. An estimated $20 million in revenues was
forgone in FY 2003 because of the credit.14
Magnitude of Small Business Tax Benefits
This partial description of existing small business tax preferences amply
illustrates the varied ways in which the current federal tax code favors the formation
of small firms and fosters their growth, at least up to a certain size. But it also raises
the question of to what extent smaller firms are favored by the tax code.
One way to address this question is to compute and compare the user cost of
capital for firms that are able and unable to expense part or all of their investments
in qualified assets under IRC section 179. While not all small firms are able to claim
the expensing allowance, it is one of the most significant tax preferences available
to these firms because of its impact on small business investment. Expensing
stimulates this investment by reducing the required rate of return (or user cost of
capital) for investments in qualified assets.
Table 1. Estimated User Cost of Capital Calculations
Under Expensing (%)
Corporate
Expensing
Regular Depreciation
Subsidy
Tax Rate
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.
a The calculations assume that the interest rate is 9%, inflation 3%, and the rate of economic
depreciation 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.
14 Ibid., table 6-1, p. 105.

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Table 1 summarizes the results of an analysis by Douglas Holtz-Eakin of the
effect of expensing on the user cost of capital.15 The first column gives the corporate
tax rate; the second shows required pre-tax rate of return if the entire cost of the
investment can be expensed; the third column provides the required pre-tax rate of
return if the entire cost is recovered through normal depreciation allowances allowed
under the Modified Accelerated Cost Recovery System; and the final column displays
the effective tax subsidy arising from expensing, expressed as the difference in
percentage points between the required rates of return shown in columns three and
two. What stands out among the figures in the table is that expensing delivers a
significant tax subsidy for investment, and that the magnitude of the subsidy rises
with a firm’s marginal tax rate. For example, at a tax rate of 15%, expensing lowers
the user cost of capital by about 11%; but at a rate of 35%, the reduction leaps to
28%. At the same time, the user cost of capital under expensing rises together with
the tax rate because tax deductions become less valuable at lower tax rates.
Legislative Initiatives in the 108th Congress to
Enhance or Expand Current Small Business
Tax Subsidies
Underscoring the enduring appeal of small entrepreneurial firms and the
political influence of small business owners, a number of legislative initiatives to
enhance or expand existing small business tax subsidies have already been
introduced in the 108th Congress. At least 19 bills (some of which are identical), in
whole or in part, have such a purpose.16 They vary in scope from something as
seemingly minor as relaxing the eligibility requirements for S corporations (H.R. 714
and S. 850) to something as seemingly major as creating new permanent tax credits
for some of the costs to small firms of offering health insurance coverage to their
uninsured employees (e.g., H.R. 450 and S. 906).
In the 107th Congress, many proposals to enhance or expand small business tax
benefits were considered. But only one measure containing such benefits was
enacted: the Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA, P.L. 107-16). Among other things, the act established a new 10% tax
bracket and put in place a timetable for the gradual reduction in the 28% bracket to
25%, the 31% bracket to 28%, the 36% bracket to 33%, and the 39.6% bracket to
35%, between July 1, 2001 and July 1, 2006. These rate reductions increased the tax
advantage of operating a small firm as a passthrough entity rather than a corporation
and shrank the tax burden on owners of such entities.17 There is some fresh evidence
15 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.)
16 This total excludes bills that would have boosted tax benefits for small firms in particular
industries such as property and casualty insurance or small firms investing in specific
geographic regions such as federally designated empowerment zones.
17 In early 2001, President Bush proposed lowering the top individual tax rate from 39.6%
(continued...)

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that tax rate reductions can set the stage for faster growth in small business output in
the short run.18 EGTRRA also created a 50% non-refundable tax credit for the first
$1,000 in administrative and educational expenses incurred by certain small
employers in setting up new qualified pension plans for employees.
Bills in the current Congress to enhance or expand small business tax
preferences or to simplify their tax accounting and compliance are identified below:
IRC Section 179 Expensing Allowance
A majority of the bills, which number 12 so far, would make the expensing
allowance available under IRC section 179 more generous, either temporarily or
permanently.19 Some of the bills are modeled after a proposal made by President
Bush in his budget request for fiscal year 2004, which calls for increasing the
expensing allowance from $25,000 to $75,000 and the phase-out threshold from
$200,000 to $325,000, indexing both amounts for inflation, and including off-the-
shelf computer software in the depreciable assets eligible for expensing; the changes
would take effect on January 1, 2003 and be permanent.20 Notable legislative
initiatives to implement this proposal include S. 2, as passed by the Senate Finance
Committee on May 8, 2003. A version of the bill passed by the House Ways and
Means Committee a day earlier (H.R. 2) would raise the allowance to $100,000 and
the threshold to $400,000 in 2003 through 2007. By contrast, some bills would
temporarily expand the allowance, mainly as part of a package of measures intended
to stimulate faster economic growth. For example, S. 414, introduced by Senate
Minority Leader Thomas Daschle, would raise the expensing allowance to $75,000
and the phase-out threshold to $325,000 in the 2003 tax year only, among other
things.
17 (...continued)
to 33% between 2001 and 2006. The Treasury Department’s Office of Tax Analysis
estimated that 800,000 small business owners and entrepreneurs would benefit from this cut.
It also estimated that these same individuals would receive 77% of the tax relief provided
by this reduction. See Patti Mohr, “O’Neill Gives Small Businesses Reassuring Tax Cut
Prognosis,” Tax Notes, vol. 91, no. 7, May 14, 2001, pp. 1053-1055.
18 In a recent analysis of the impact of personal income tax rates on the growth of small
firms using tax return data from just before and just after the Tax Reform Act of 1986 took
effect, Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen found that
when a sole proprietor’s marginal tax rate rose by 10%, his business receipts went up 8.4%.
This implied that a reduction in the marginal tax rate levied on a sole proprietor from 50%
to 33% would lead to a 28% increase in his or her receipts. See Robert Carroll, Douglas
Holtz-Eakin, Mark Rider, and Harvey S. Rosen, Personal Income Taxes and the Growth of
Small Firms, Working Paper 7980, National Bureau of Economic Research (Cambridge,
MA: Oct. 2000).
19 The bills are H.R. 2, H.R. 22, H.R. 179, H.R. 224, H.R. 1079, H.R. 1126, S. 2 (identical
to H.R. 2), S. 106, S. 158 (identical to H.R. 179), S. 414, S. 513, and S. 842.
20 For an assessment of the likely economic effects of such a proposal, see CRS Report
RL31852, Small Business Expensing Allowance: Proposals in the 108th Congress to
Enhance It and Their Likely Economic Effects, by Gary Guenther.

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Exclusion of Gains on Certain Small Business Stock
Two bills (S. 106 and S. 842) would expand the partial exclusion of long-term
capital gains on the sale or exchange of small business stock under IRC section 1202.
The former would increase the share of gains that can be excluded from 50% to 75%
for firms not classified for tax purposes as “empowerment-zone businesses.” It
would also shrink the minimum holding period for small business stock to qualify for
the exclusion from five years to three years, repeal the current requirement that 42%
of any excluded gain be treated as an individual AMT preference item, relax existing
restrictions on working capital held by qualified small firms, increase the cap on the
gain eligible for the exclusion from $10 million to $20 million for married couples
filing joint tax returns, and expand the range of business activities eligible for the
exclusion to include biotechnology and fish farming.
S. 842 would also allow taxpayers to exclude 75% of the capital gains on
qualified small business stock, but it would create a 100% exclusion for stock issued
by “critical technology” corporations and specialized small business investment
companies. A corporation would be considered a “critical technology corporation”
if, during the minimum holding period for the exclusion, “substantially all” the firm’s
active business is focused on technologies related to national defense, homeland
security, transportation, anti-terrorism, environmental improvement, or improved
energy efficiency. In addition, the bill would reduce the minimum holding period for
qualified small business stock from five to four years, allow corporations to claim the
exclusion, and double the asset size (from $50 million to $100 million) of C
corporations eligible to issued qualified small business stock and index the amount
for inflation beginning in 2005.
Expanded Eligibility for S Corporation Status
Two bills (H.R. 714 and S. 850) would expand the range of firms eligible to
become S corporations and thus avoid paying the corporate income tax. Among
other things, each measure would exclude certain investment income from the
definition of passive income for an S corporation bank, increase from 75 to 150 the
maximum number of shareholders an S corporation may have, allow trusts that are
individual retirement accounts to become S corporation shareholders, allow a bank
director to own stock in an S corporation without the stock being considered a
disqualifying second class of stock, and allow S corporations to issue qualified
preferred stock.
Tax Credit for Small Firms Offering Health Insurance to
Employees
At least five bills would establish a refundable or non-refundable tax credit for
part of the cost to small employers of offering health benefits to employees: H.R.
450, S. 53, S. 86, S. 414, and S. 906. While they differ in such important details as
the size of the credit rate and eligibility criteria for firms and eligible employees, they
share the policy aim of expanding health insurance coverage by giving small
employers who currently do not offer health insurance coverage to employees an
incentive to do so. For example, H.R. 450 would establish a refundable tax credit

CRS-13
equal to 50% of employer health insurance contributions for firms with 10 or fewer
employees; the credit rate drops to 25% for firms with 11 to 15 employees; and it
reaches 0% for firms with 16 or more employees. The credit applies only to health
insurance premium payments made on behalf of employees who work at least 400
hours and earn $40,000 or less in a calendar year. In addition, the employer must
cover at least 75% of the cost of the insurance coverage. By contrast, S. 53 would
create a non-refundable tax credit equal to 25% of the cost of individual health
insurance coverage up to $750 per eligible employee and 35% of the cost of family
coverage up to $2,450 per eligible employee. The credit may be claimed only by
firms employing an average of 25 or fewer workers in either of the two preceding
calendar years.
Special Amortization Deduction for Intangible
Assets Acquired from Certain Small Firms
H.R. 1222 would change IRC Section 197 to permit taxpayers to claim a special
amortization deduction for any intangible assets acquired from an eligible small firm.
Under current law, the value of these assets must be amortized over 15 years. Assets
eligible for this treatment include goodwill, covenants not to compete, patents,
copyrights, licenses, permits, and trademarks. The bill would allow the owner of the
acquiring firm to write off the first $5 million in intangible assets acquired from an
eligible firm in the year of purchase, and the remainder would be amortized over 14
years, including the year of purchase. An eligible firm is defined as one with annual
gross receipts of $5 million or less in each of the three previous tax years.
Economic Arguments For and Against
Small Business Tax Subsidies
Current small business tax preferences and congressional initiatives to expand
them pursue a variety of policy goals. Among the noteworthy goals are simplified
tax accounting for small firms, improved access to long-term equity capital for small
firms, increased investment by small firms, and expansion of the proportion of
Americans covered by health insurance. But regardless of this diversity of aim,
current and proposed small business tax benefits find common ground in their use of
preferential tax treatment targeted at small firms.
Existing small business tax subsidies and proposals to expand them raise some
interesting and important policy issues. For public finance economists, a key issue
is whether or not such subsidies can be justified on economic grounds? Another way
to frame the issue is to ask whether a sound argument based on principles of
economic equity or efficiency can be made in favor of small business tax subsidies.
The answer has important implications for social welfare, since perhaps as much as
$5 billion is transferred annually to small firms through the federal tax code. If the
economic rationale for these tax subsidies turns out to be weak or untenable, then it
can be argued that channeling these resources into other applications could lead to
higher levels of social welfare. At the same time, it is important to keep in mind that
small business tax subsidies are supported on a variety of non-economic grounds, and

CRS-14
that these arguments may outweigh purely economic considerations in the minds of
policymakers evaluating proposals to expand them.
Nevertheless, the central focus of this section is the economic arguments for and
against such proposals and their relative merits. These arguments are explored
below.
Chief Economic Arguments in Favor of the Subsidies
In general, proponents of small business tax subsidies cite the special economic
role played by small firms, the barriers to their formation and growth, and the
opportunities for individual economic advancement offered by small business
ownership as the primary economic justifications for the subsidies.
Elements of this rationale surface from time to time in congressional debates on
proposals 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.”21 And early in the current Congress, Senator Olympia Snowe stated on the
floor of the Senate, in introducing legislation to expand the small business expensing
allowance, that “they (small businesses) represent 99 percent of all employers,
employ 51 percent of the private-sector workforce, provide about 75 percent of the
net new jobs, contribute 51 percent of the private-sector output, and represent 96
percent of all exporters of goods.”22 Both statements draw on data reported by the
Small Business Administration.
Proponents of small business tax subsidies also look beyond the direct and
immediate economic contributions 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 defense of 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 even be found in industries
characterized by large production runs and falling unit costs such as automobiles and
21 Sen. Christopher Bond, remarks in the Senate, Congressional Record, daily edition, vol.
147, Jan. 25, 2001, p. S576.
22 Sen. Olympia Snowe, remarks in the Senate, Congressional Record, daily edition, vol.
149, no. 6, Jan. 14, 2003, p. S299.

CRS-15
steel.23 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 in recent decades. Two notable
findings arising out of 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 relatively low levels of concentration.24 The same literature offers fresh
evidence that in certain industries small start-up firms are more adept than large
established firms at identifying promising markets and applications for new
technologies and exploiting these opportunities. During the 1980s and 1990s, several
dramatic illustrations of this tendency emerged in biotechnology, microelectronics,
computer software, and electronic commerce.25
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 the growth process 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.”26
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 of the United States. In addition, they claim that women-,
minority-, and immigrant-owned small firms benefit their communities and society
at large in ways that go beyond direct economic contributions. 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 including self-employed women who
23 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.
24 Joshua Lerner, “Small Business, Innovation, and Public Policy,” in Are Small Firms
Important? Their Role and Impact, p. 160.
25 Ibid., p. 160.
26 Bo Carlsson, “Small Business, Entrepreneurship, and Industrial Dynamics,” p. 109.

CRS-16
work out of their homes are more stable than the average family.27 And in the case
of minority and immigrant groups, small business ownership helps to lay the
foundation for building tight-knit social networks, providing job and skills training,
and creating informal capital markets.28
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 and expand it. If capital markets
were truly efficient, then every small business investment project 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
that such is not the case. They argue that largely because of a lack of information on
the part of investors, too 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
failing.
Chief Economic Arguments Against the Subsidies
While acknowledging the significant economic role played by small firms, some
economists maintain that their contributions to economic activity do not justify
targeting tax subsidies at small firms. Among public finance economists, a
conventional rationale for government intervention in the economy is the presence
of a market failure. In general, market failures can be thought of as economic
conditions that produce undesirable efficiency or equity effects. Foremost among
these conditions are a lack of perfect competition, the presence of public goods and
positive or negative external effects (or externalities), the existence of incomplete
markets, and imperfect information on the part of consumers.29 Critics of small
business tax subsidies say there is no evidence that a market failure hinders the
formation or growth of small firms. What is more, they add, such subsidies are likely
to result in undesirable or unintended equity and efficiency effects.
Equity Concerns.
Critics charge that small business tax preferences undercut the progressivity of
the federal individual income tax. Under a progressive income tax, a taxpayer’s tax
liability hinges on his or her taxable income, and taxpayers with higher taxable
incomes pay more in tax than taxpayers with lower taxable incomes. Moreover, it
is thought that individuals, and not firms, ultimately bear the burden of business
27 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.
28 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.
29 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.

CRS-17
income taxes. While all owners of capital stand to benefit ultimately from small
business tax subsidies, 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.30 In effect, the benefits reduce the tax burden on small business
owners.
Efficiency Concerns.
Critics also find fault with small business tax subsidies on efficiency grounds.
They point out that, in theory, the tax code should not prevent economic resources
from migrating to their most productive uses. In practice, this notion has a number
of important policy implications. First, it implies that economic activities, including
investment, should be taxed at uniform rates. Second, the theory of neutral taxation
also implies that any tax on a factor of production or output that is not uniform across
firms may harm social welfare.31 Finally, it implies that taxes should not distort a
firm’s choice of inputs or its investment or production decisions. Critics maintain
that an efficient 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.32

Critics also challenge the claim that there is something unique about the
economic role of small firms that would warrant the use of targeted tax subsidies.
More specifically, they argue there is no conclusive proof that small firms are
demonstrably and consistently superior to large firms in creating jobs or hatching
important technological innovations.

Critics and proponents alike agree that small firms generally are a fertile source
of job creation. According to data from the U.S. 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.33 But
critics maintain that for a variety of reasons these data do not necessarily prove that
30 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, 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
Business Administration (Washington: May 16, 2001), pp. 24 and 27.
31 Stiglitz, Economics of the Public Sector, pp. 567-569.
32 Douglas Holtz-Eakin, “Should Small Businesses be Tax-Favored?,” National Tax Journal,
vol. 48, no. 3, Sept. 1995, p. 390.
33 U.S. Small Business Administration, Office of Advocacy, Small Business FAQ,
(Washington: Dec. 2000).

CRS-18
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?
In addition, critics cite what they see as 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: David Birch and James Medoff estimated that the share of
total new jobs generated by firms employing 100 or fewer workers varies from about
40% to 140%, depending on the stage of the business cycle.34 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.35 Third, 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, at times, from large back to small, suggesting that their job-creating
ability was unstable at best.36 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.37
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
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. 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 unwilling or unable to
34 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.
35 Ibid., p. 8.
36 Birch and Medoff, “Gazelles,” pp. 162-164.
37 Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction
(Cambridge, MA: MIT Press, 1996), pp. 169-170.

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provide investors with the information they require to evaluate the potential returns
on planned R&D investments.38 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 evidence suggesting
both small and large firms are responsible for the innovations 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, on average, whereas companies with 10,000 or more
employees were responsible for 59% of this spending, on average.39 Nonetheless,
small firms and large firms each appear to have advantages as agents of technological
innovation.40 In addition, numerous studies have been done of the effects of firm size
and market structure on innovation.41 On the whole, they suggested that no firm size
was 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 continuous supply of 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 tax subsidies to small firms. They point out that only a tiny share of small
start-up firms survive and grow to the point that they pose a serious competitive
threat to large entrenched firms in the same business. From their perspective, antitrust
38 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.
39 National Science Board, Science & Engineering Indicators — 2000, Vol. 1 (Arlington,
VA: 2000), appendix table 2-54, pp. A-97 and A-98.
40 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.
41 F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance,
3rd edition (Boston: Houghton Mifflin Co., 1990), pp. 651-657.

CRS-20
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, 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 capital 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 a 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 powerful disincentive to grow beyond that limit. The expensing
allowance under IRC section 179 offers an illustration of this pitfall. As a firm raises
its investment in assets that qualify for the allowance beyond $200,000, the amount
that may be expensed is reduced dollar for dollar, ultimately to zero starting at
$225,000. In effect, this rule gives firms an incentive to invest no more than $25,000
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 $25,000, 26% on
amounts over $25,000 to $200,000, 43% on amounts over $200,000 to $225,000, and
26% on amounts above $225,000.42 Economist (and current Director of the
Congressional Budget Office) 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.43
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, commercialize many technological innovations,
and serve as agents of renewal and structural change in a variety of industries.
These contributions explain part of the widespread support inside and outside
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 exceeds $5.0 billion in FY2003. A
42 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.
43 Holtz-Eakin, “Should Small Businesses Be Tax-Favored?,” p. 393.

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variety of initiatives to expand these subsidies — especially the expensing allowance
under IRC section 179 — are attracting attention 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, 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 activities 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 evidence that small
entrepreneurial firms play critical roles in production, 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 case on economic grounds for government intervention. A
possibility would be capital market imperfections that 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 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 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.
Holtz-Eakin has noted that the use of such a model would help to determine whether
any market failures are hampering the formation and growth of small firms and, if so,
to identify the factors that shape these failures and are amenable to correction through
policy intervention.44
44 Ibid., p. 393.