The myth of small business as a job engine
The biggest winner of this week’s presidential debate was not Republican presidential nominee Mitt Romney or President Barack Obama. It was small business.
Each candidate claimed his economic policies would do more to help small companies prosper. Romney went further when he swatted down Obama’s proposal to raise income taxes on the rich by claiming it would hurt small-business owners and thus snuff out job creation.
Yet to portray small businesses as the engine of job growth is to vastly overstate their role. The argument that raising tax rates on upper-income individuals would harm entrepreneurs is likewise flawed. We love small business as much as anyone. But with the United States facing unsustainable budget deficits that will require many Americans to pay higher taxes, it’s worth separating fact from fiction.
First, small businesses destroy almost as many jobs as they create. Second, only about 3 percent of small-business owners fall into the upper-income tax brackets that would increase if, as Obama has proposed, the Bush tax cuts are allowed to expire. And third, many businesses counted as small aren’t engaged in traditional small-business activity. Instead, they are partners in hedge funds, law firms and private-equity shops, or they are highly paid actors, athletes, speakers and authors.
Small businesses are being drawn into the political discussion because of the way they are structured. To avoid paying corporate income taxes, many small-business owners report profits on their individual tax returns. These “pass-through” entities include sole proprietorships, partnerships, limited liability companies and S corporations. Some of them are very profitable, but a large number aren’t what most of us would consider a small business, such as a dry cleaner or coffee shop.
One reason for the confusion is that there is no universal definition. The Small Business Administration counts companies with as much as $35.5 million in sales and 1,500 employees, depending on the industry. Outside government, companies with less than $7 million in sales and fewer than 500 employees are widely considered small businesses.
Two recent reports by Ernst & Young — one commissioned by the S Corporation Association and another by the National Federation of Independent Business — took the broad view. They concluded that pass-through companies accounted for almost 95 percent of all business entities in 2008 and employed 54 percent of the private-sector workforce. Romney’s debate-night assertion that the tax increase would cost 700,000 jobs stems from these studies.
Such findings, though, are at odds with those of several other studies, including one in 2011 by the U.S. Treasury Department. It attempted to better define small business by looking at criteria such as income, labor, and other business expenses and tax deductions. Its conclusion: “Many filers are not engaged in business activity as it is traditionally understood.” Just 20 million of the 34.7 million filers reporting pass-through income qualified as a small business, Treasury said. Of those, about one-fifth qualified as an employer.
True, most small-business wealth is accumulated at the top. The 3 percent of filers with pass-through income in the upper brackets account for half of all pass-through income.
Yet it isn’t at all clear that raising taxes on the high- income group would depress hiring and investment. For one thing, small businesses enjoy a host of tax breaks, including the ability to immediately deduct many costs as a business expense.
More important, recent economic research shows that small companies play no greater role in job creation than large ones do. What matters more is age: New businesses account for the biggest share of job gains. Those companies tend to be small yet unprofitable. They would be largely unaffected by an upper-income tax increase. Once most startups pass the five-year mark, they destroy more jobs than they create.
University of Maryland economist John Haltiwanger found, for example, that small mature businesses have “negative net job creation” and the bigger contributors to job growth are startups, which account for roughly 3 percent of employment in most years.
Alan Viard, a resident scholar at the American Enterprise Institute, says the argument that small business creates jobs “does not stand up under scrutiny.”
Small business is important and the U.S. should continue policies that enable entrepreneurs to bring their ideas to life, including tax breaks for hiring new workers and deductions for expenses.
The U.S. faces a serious financial shortfall that will require many Americans, including the wealthiest, to pay higher taxes. Republicans can argue against tax increases for many reasons, but hampering small business isn’t one of them.