Why Small Business Should Not Get a Veto Over Corporate Tax Reform

November 7, 2016
Corporate tax reform, especially reducing the effective rates on investment and research and addressing taxation of foreign-source income, is too important to be held up by any one special interest group.

Over the last several years, a great deal of effort has gone into trying to update the nation’s corporate tax laws for the 21st century. Unfortunately, many in the small-business lobby have actively opposed these efforts, arguing that current proposals would hurt their interests. Given the difficulty of passing any major policy reform, this opposition could be enough to defeat any legislation. Yet small-business concerns about corporate tax reform are misplaced largely because, as a group, small businesses are already taxed at a significantly lower rate than larger corporations. Pro-growth corporate tax reform, especially reducing the effective tax rates on investment and research and addressing taxation of foreign-source income, is too important to the nation’s economy to be held hostage by any one special interest group. 

It has been 30 years since the Tax Reform Act of 1986, the last major overhaul of individual and corporate tax rates. Since then, the world has changed a great deal, but tax law has not kept up. Although both individual and corporate taxes need reform, Congress and the administration are rightly focusing largely on reducing effective corporate tax rates now. 

The focus on corporate reform is due to several factors. Less agreement on individual tax policy exists between Democrats (who think that marginal tax rates on the rich should increase and that tax reform should raise revenue in order to pay for more spending) and Republicans (who are more concerned about the negative incentive effect of high tax rates and have pledged not to raise taxes). Moreover, large individual tax expenditures, such as the exclusion of employer-paid health care, and deductions for mortgage-interest payments and state and local taxes are extremely popular, even though they are highly regressive and encourage unproductive behavior. Finally, almost everyone agrees that corporate reform is more urgent. 

The high statutory corporate tax rate and its application to all worldwide income are leading to a number of troublesome trends. One is that the high tax rate reduces the incentive for U.S.- and foreign-owned corporations to invest in the U.S. economy. Another is that U.S. corporations face a higher effective tax rate than their foreign competitors when they vie for foreign markets. This competitive pressure has led a number of American firms either to move their headquarters abroad or to agree to be purchased by overseas companies. Finally, a number of countries have recently taken actions to claim a larger share of the U.S. corporate tax base, either by claiming that multinationals unfairly minimize the amount of profits earned in their jurisdictions, or by levying a higher tax rate on the profits they do declare. 

Unfortunately, the momentum for reducing the corporate tax rate has been stalled for several years by strong opposition from interest groups representing small businesses. For instance, an Issue Brief by the National Small Business Association opposes corporate-only reform as being unfair to the majority of its members. When congressional Republicans and President Obama tried to negotiate corporate tax reform in 2015, a top official at Associated Builders and Contractors stated: “Given the option, this or nothing, nothing is better for our members.” 

The vast majority of small businesses are not subject to the corporate income tax. Instead, these businesses are structured as sole proprietorships, partnerships, or S corporations. Their income automatically passes through the business and appears on the owners’ individual tax returns, whether or not there has been any dividend or sale of ownership. The number of these entities has grown substantially over the past several decades. In 2011, these three forms of businesses accounted for almost 95 percent of business returns, but just 28 percent of business revenues. 

To be sure, a lower corporate tax rate will not directly benefit pass-throughs. This will harm the relative competitiveness of smaller firms (although they will still likely face a much lower tax burden than corporate shareholders do). Moreover, to the extent that a lower corporate rate is paid for by eliminating business exemptions or deductions that smaller companies use, these companies could actually see their effective rates increase (although it is very possible that most of the provisions eliminated will be ones that pass-throughs seldom use). 

These concerns should not be allowed to hold up corporate tax reform and its key component: a reduction in the statutory and effective corporate rates, especially on companies that compete internationally and on activities such as research and development, which deliver broad economic benefits. For such reform is pro-growth and on net would likely lead to net benefits for most small business in the form of higher sales. Moreover, the arguments that small business advocates put forward for why corporate-only reform is unfair to them and economically harmful are largely false and should be ignored by Congress.

Why Small Business Should Not Get a Veto Over Corporate Tax Reform