SMALL BUSINESS TAX CREDITS LIKELY TO COST JOBS, BENEFIT WEALTHY, SAYS GRAVELLE.

                          Jane G. Gravelle

The Clinton Administration included in its stimulus package several permanent tax subsidies for investments. The largest single incentive, amounting to over $3 billion after five years, was an equipment investment tax credit for small businesses. A second provision, allowing a targeted capital gains tax benefit for small corporations, was estimated to lose $247 million.

Economists, using a conventional analysis of capital income taxation, seldom find justification for the targeting of investment incentives to a particular type of investment, or to small businesses. Economic analysis suggests that capital is allocated efficiently and the economy is most productive, absent some market failure or other existing distortion, if all capital is taxed at the same rate.

In fact, most of these small businesses are already favored under current tax law, and the proposed tax changes will further magnify these differences. For a typical investor, the tax burden on investment in an unincorporated business is about half that for a corporate investment; with the new subsidy for equipment, noncorporate equipment investments will be taxed at rates one fourth the size of those in the corporate sector.

The justifications advanced for favoring small business are questionable. The claim that small businesses create the large majority of jobs is based on previous studies that have since come under attack. Moreover, if the target of the subsidy is to increase employment, a benefit for CAPITAL (a competing factor) may not be appropriate. Indeed, a capital subsidy can decrease employment in small businesses by encouraging firms to substitute capital for labor. Furthermore, economic analysis suggests that job creation is not an appropriate objective of permanent tax policies. Moreover, growth in employment is not necessarily a sign that a sector is more efficient.

The claim that small businesses are more innovative than large ones, within an industry, is also subject to question. In any case, most of the benefits of the provisions would be concentrated in the trade, service, and other sectors of the economy where technological innovation is not very important, because that is where small businesses are concentrated.

The benefits of the provision would tend to accrue to higher- income individuals. Owners of small businesses have incomes that are, on average, eighty percent higher than average; they have more than five times the capital of the average family. Only a small proportion of taxpayers are likely to benefit directly: in 1985 only five percent of returns claimed an investment credit.

There are also a number of administrative problems associated with these provisions including multiple ownership of businesses and the need for tracing and attribution rules, and the possibility of adjusting timing of receipts and investments.

                              CONTENTS

This report explains the provisions, discusses the economic impact, and considers arguments for special tax benefits for small businesses.

EXPLANATION OF PROVISIONS

SMALL BUSINESS INVESTMENT CREDIT

Like preexisting investment credits (which were repealed as part of the Tax Reform Act of 1986), the credits would apply to investment in tangible personal property. Examples of such qualified investment include furniture and fixtures, trucks, cars, tractors, construction equipment, aircraft, computers, and machinery used in factories. A credit offsets the cost of the investment; hence, for a 5 percent credit, the taxpayer would reduce taxes by $5 for each $100 of qualified investment. The amount of investment which can be depreciated (deducted over the tax life of the asset) would be reduced by the credit. Thus, in the previous example, only $95 could be depreciated.

The President's package contains temporary investment credits for large businesses, in the form of incremental credits (credits for investment in excess of a base amount of previous spending). Credits for small businesses are not incremental and are permanent. The initial credit rates for both the large and small businesses are set at 7 percent in the first year and 5 percent in the second. The small business credit continues at a permanent 5 percent rate. For both credits, the full rates (7 percent and then 5 percent) apply to equipment depreciated over a period longer than seven years. For equipment depreciated over a shorter period, the investment credit would be reduced. For property depreciated currently over three years, one-third of the credit would be allowed; for property depreciated over 5 years, two-thirds of the credit would be allowed; for property depreciated over 7 years, four-fifths of the credit would be allowed.

The small business credit can be claimed in any year if the firm has receipts of less than $5 million. There is no gradual phase-out of the credit; a business with receipts of $5 million or more is simply ineligible.

Present law allows firms to expense the first $10,000 of equipment investment. Presumably this benefit will not be allowed if the investment tax credit is taken. In most cases, the expensing option is more beneficial than choosing the credit and normal depreciation; even in the 15 percent bracket, the two are quite close in value. Thus, for very small businesses that do not purchase much equipment, there would be little or no benefit from the proposed investment credits.

TARGETED CAPITAL GAINS PROVISION

The targeted capital gains provision would allow taxpayers who have stock in small businesses with capitalization of less than $25 million to exclude from taxable income one half of the capital gain on certain stock. To be eligible, stock must be original issue and held for at least five years. This treatment applies only to businesses that are taxed as corporations (that is, Subchapter S corporations that elect partnership treatment are not included). Businesses engaged in certain types of activities are excluded -- these include personal services, banking, leasing, real estate, farming, mineral extraction, and hospitality businesses.

CONVENTIONAL ECONOMIC ANALYSIS

Economists, using a conventional analysis of capital income taxation, seldom find justification for the targeting of investment incentives to a particular type of investment, or to small businesses. Economic analysis suggests that capital is allocated efficiently and the economy is most productive, absent some market failure or other existing distortion, if all capital is taxed at the same rate.

In fact, small businesses are already favored under current tax law. Most small business investment credits will be claimed by unincorporated businesses. Unincorporated businesses are subject to lower tax rates than corporations since they do not bear the double tax on corporate equity income and because individual tax rates are generally lower. Current individual tax rates are graduated and include brackets of 15, 28, and 31 percent. When these tax rates are weighted across asset holdings, the average tax rate tends to fall around the low to mid twenties. Small corporations are also eligible for lower tax rates than are larger corporations, because the corporate tax rate is graduated. Corporations are generally subject to a 34 percent rate, but are allowed a 15 percent rate on the first $25,000 of taxable income and a 25 percent rate on the next $25,000. The benefits of the lower rates are phased out between $100,000 and $335,000 of income, causing a MARGINAL tax rate (the rate on the next dollar of earnings) of 39 percent to be applied on earnings that fall between these levels. ¹

The magnitude of the tax differentials introduced by the Administration's proposals are shown, for an investor in the 28 percent bracket, in table 1. Further details of these calculations can be found in Appendix 1. The tax rates shown in this table are effective marginal tax rates -- they show what fraction of the pre- tax return of a new investment is paid in taxes. The marginal effective tax rate accounts for both the statutory tax rates and any special tax benefits or penalties. In the case of the corporate investment, it includes the corporate tax and individual taxes on corporate dividends and capital gains on corporate stock.

    TABLE 1: EFFECTIVE TAX RATES ON EQUITY CAPITAL, 28 PERCENT TAX

Under current law, corporate capital is taxed at an effective rate of about twice the noncorporate rate for equipment; under the new proposal, the corporate tax rate on equipment will be four times as large. Within both sectors, equipment is currently taxed at slightly lower rates than are other assets. With the new subsidy, equipment will be taxed at about one-third the rate of other assets in the noncorporate sector.

These rates reflect only the differences between investments in noncorporate businesses and investments in very large corporations. In some cases, the differentials will be slightly larger since many reasonably large corporations will be taxed at a marginal rate of 39 percent due to the phase-in of corporate rates. In other cases the rates will be slightly smaller. Currently, the corporate tax contains one bubble -- rates on marginal investment are 15, 25, 34, 39, and 34 percent. The "bubble", where the rate rises to 39 percent and then falls, results from the additional 5-percent tax imposed over a range of income in order to offset the savings from the lower 15 percent and 25 percent tax rates. Once the phase out is completed, the firm pays both an average and a marginal rate of 34 percent. Under the new proposal, corporate income over $10 million will be subject to a 36 percent rate. The tax benefits from all the lower 34 percent rate will be phased out by imposing an additional tax of 3 percent on income above $15 million. Thus the new corporate marginal tax rates (rates on the next dollar of income) will contain two bubbles: the rates will be 15, 25, 34, 39, 34, 36, 39, and 36.

Table 2 shows the effective tax rates on equity capital for very-high-income individuals. For the top individual rate bracket, the differences between the corporate and noncorporate rates for equipment are somewhat modified by the higher individual tax rates (these rates do not apply to capital gains). For those subject to the higher 36 percent rate and the 10 percent surcharge, the top rate will rise from 31 percent to 39.6 percent. These rate differentials narrow the differences for buildings and inventories and offset in part the differences for equipment.

    TABLE 2: EFFECTIVE TAX RATES ON EQUITY CAPITAL, TOP TAX BRACKET

Calculations assume 3 percent inflation rate, a real discount rate of 5 percent, 57 percent of corporate real income paid out in dividends, and half of capital gains on corporate stock realized with a 7-year holding period. The equipment rate is a weighted average of all equipment. The building is commercial.

    TABLE 3: EFFECTIVE TAX RATES ON EQUITY CAPITAL, 15 PERCENT TAX

EVALUATION OF ARGUMENTS FOR THE TAX SUBSIDIES

Three different justifications for providing these tax subsidies appear to have played some role in their development: arguments for subsidizing equipment in general, arguments that small businesses create a disproportionate share of jobs, and arguments that small businesses are responsible for a disproportionate share of innovations.

Proposals for permanent investment credits for equipment in general appear to be based largely on arguments that these are more technologically advanced and would be especially productive. Such proposals also rely on the potential use of such credits to stimulate aggregate demand in the short run. There was considerable discussion during the campaign of adopting an incremental investment credit -- a credit for investment in equipment over a base year period. Such a credit would be much less costly than a permanent credit. There is reason to believe, however, that such incremental credits are not workable in the long run and are difficult to administer and comply with even in the short run. ²

In his address to the Congress on the economic program (February 17), the President stated: "Because small business has created such a high percentage of all the new jobs in our nation over the last 10 or 15 years, our plan includes the boldest targeted incentives for small business in history." ³

The summary of tax proposals prepared by the Treasury Department (released February 25) discusses the temporary and permanent credits together and has no specific statement on the small business aspect of the credit. ⁴ Choosing a non-incremental credit for small business may have reflected concerns that administrative problems associated with an incremental credit would be too severe for small firms. There is no discussion, however, of the rationale for providing a permanent equipment credit solely for small firms. Such a credit is, however, much less costly than a credit for all firms.

With respect to the targeted capital gains proposal, the Treasury refers to the role of small businesses in economic growth and job creation, and refers specifically to investments in innovation. This proposal is similar to a targeted capital gains tax proposal originally advanced by Senator Bumpers. Such a proposal was included in H.R. 11, the tax bill passed in 1992 but vetoed (for other reasons) by President Bush.

In the following sections, each of these justifications is discussed in turn.

THE JOB CREATION ARGUMENT

The perception that small businesses create most of the new jobs dates from a study done in 1981 by David Birch that claimed that firms with less than 100 employees, which represented about 35 percent of the labor force, created 8 out of 10 jobs over the period 1969-1976. ⁵ These figures are still cited occasionally.

A subsequent study by Armington and Odle found that these firms accounted for about 38 percent of new jobs, roughly in proportion to their numbers, for 1978-80. ⁶ Armington and Odle suggested that Birch had counted as small firms businesses that were simply outlets of larger firms.

Brown, Hamilton, and Medoff have looked carefully into the issue of job creations by small firms, making several important points. ⁷ Based on a study by the Small Business Administration, they report that the Birch numbers did overstate the share of jobs created -- during the period he studied these firms accounted for 56 percent of new jobs. ⁸ There is also considerable variation across different time periods -- in some intervals these small firms accounted for virtually all growth. On average, firms with less than 100 employees seem to account for about half of jobs created from 1976 to 1986, more than their share in the labor force in 1980 of 35 percent. (These shares are similar to those of the period 1969-76.) Firms with less than 500 employees accounted for about 60 percent net new jobs over the same time period, with a labor force share of about 50 percent.

These authors also had some other interesting insights into the figures on job creation by small firms. Although the data suggest that small businesses in general created new jobs in excess of their share of the labor force, there were two important qualifications to this observation. First, part of the growth reflected the fact that industries that tended to be dominated by small firms had been growing. The increased jobs by new firms may not have been so much because small firms were doing better than larger ones, but rather because the industries in which small firms operated were growing, perhaps for unrelated reasons.

Secondly, they point out that most of the jobs were created by new firms, which tend, of course, to be small. (Firms are not usually "born" large.) According to Brown, et al., the majority of these jobs will not persist because the firms will fail -- from 60 to 80 percent of new firms fail within the first few years. The data reflect a blending of small firms and new firms.

On the whole, the authors suggest that there is little evidence that small firms disproportionately create jobs, especially if one is concerned with permanent jobs. They also point out that jobs in small firms tend to pay lower wages, have fewer fringe benefits, have poorer working conditions, and tend to be less secure than jobs in larger firms.

In addition to the question of the factual basis for the job creation argument, two important points should be made about this argument.

First, if increasing the number of jobs created by small firms were the objective of the investment credit, the subsidy is questionable. It subsidizes not wages, but rather a competing factor -- investment in equipment. It favors those firms that are capital intensive. Such a subsidy might even REDUCE employment in small businesses because it encourages the substitution of capital for labor.

More importantly, however, even if more job growth accrued to small firms, this does not necessarily mean that subsidizing them will create more new jobs or even that such firms are more productive in some way than large firms. ⁹ Economic theory suggests that there is no reason to view job creation as a long-run objective of government policies. The economy can generate the jobs needed by the natural process of growth and market adjustment. In 1961 and in 1991 the unemployment rate was the same -- 6.7 percent. Employment, however, rose from 66 million to 117 million. Employment tends to grow steadily; the unemployment rate fluctuates. Federal policies may, of course, be needed to smooth out short term cycles, but even in these cases it is the aggregate stance of fiscal policy that should be evaluated with respect to job creation, and not a specific program. ¹⁰

In sum, the validity of the job creation argument can be questioned on three grounds: the factual basis of the argument, the association between the form of the incentive and its effect on employment, and the general use of the job creation justification for such a government program.

THE ARGUMENT FOR SUBSIDIZING EQUIPMENT

A considerable amount of discussion of tax policy towards investment is related to some notion of "productive" investment. "Productive" investment is often identified as high-tech investment, equipment, manufacturing investment, investment used in export industries, or whatever, and often excludes certain assets such as commercial buildings (e.g. shopping centers), or businesses such as trade and services (e.g. McDonalds).

On a simple level, the small business investment credit does not seem to be targeted to the above investments. Small businesses tend to operate largely in industries such as trade, services, agriculture, and construction. Table 4 presents estimates of the distribution of the small business investment tax credit by industry. As this table indicates, over 60 percent of the credit would accrue to trade and services. A large proportion of the assets in these industries are for cars, trucks, and furniture; the remainder would frequently be investments which are not especially "high-tech." These industries in general would not fit the model of either "high-tech," manufacturing investment, or investment used in exports. Only 5 percent accrues to manufacturing.

     TABLE 4: ESTIMATED DISTRIBUTION BY INDUSTRY OF SMALL BUSINESS

There are several reasons underlying the popular notion of subsidizing assets, particularly equipment, as more "productive" assets. The first is that investment in equipment is associated with advancements in technology more than investments in other assets such as structures and inventories. Since this technology is embodied in equipment, there is the notion that more investment in equipment will result in a more technologically advanced productive process. The fallacy in this reasoning is that equipment should be scrapped in favor of more advanced forms only when the return from replacing the equipment is high enough to justify such investment. The market will determine the desirable rate at which technology becomes embodied in the capital stock.

There also tends to be an identification in people's minds of equipment with manufacturing, which in turn is often associated with export industries and international trade. Considerable concern has been expressed about the economic performance of some of our trading partners and arguments that certain U.S. industries have had a decline in their share of international markets. Indeed, one of the current arguments invoked to justify tax benefits is that they will aid in "international competitiveness," a term without rigorous economic meaning. Often the successes of trading partners, such as Japan and Germany, are identified as resulting from government intervention to enhance this "international competitiveness."

Again, however, the classical economic theory of comparative advantage would dismiss this notion. Such theory teaches that countries will, and should, for maximum efficiency, trade in those goods in which they have an advantage compared to other countries. Again, absent externalities and trade barriers, the market will automatically achieve an efficient outcome. The changing patterns of international trade largely reflect these comparative advantages, as well as other factors such as the export or import of capital. It should not be surprising, for example, that a country like Japan, with a dearth of natural resources and a high savings rate, should be a net exporter of manufactured products. (The investments of the Japanese in other countries, a natural result of its high savings rate, can only be made real via a net export of goods.)

There are, of course, inefficient barriers to trade, such as tariffs and market restrictions. Subsidizing manufacturing in the United States would likely not improve our welfare, and might worsen it.

In sum, the argument for an investment credit for equipment based on the "greater productivity of equipment" can be questioned on two grounds: the tendency for most small businesses to be concentrated in industries that are not targeted by this argument and the lack of evidence that equipment is actually more productive than other investments.

INNOVATION BY SMALL FIRMS

Another justification advanced for targeting small businesses is the argument that small businesses are likely to be more innovative.

As in the case of the other rationales, this argument can be questioned on several grounds. There is an economic justification for subsidizing research and development, which produces spill-over effects. Such investment tends to be undersupplied in a market economy because these innovations can be copied by others and the innovating firm does not earn the total return on its investment. Whether tax subsidies are preferable to direct subsidies, or are necessary given patent protection is, however, uncertain. But, in any case, innovation is not likely to arise from the purchase of furniture and fixtures, cars and trucks, and the other types of equipment that are typical of trade and services.

This concern for the types of firms that would receive the tax benefits probably led to the exclusion of banking, personal services, agriculture, and similar firms from coverage of the targeted capital gains tax cut. Even with these exclusions, however, the benefits tend to be concentrated in trade and services. Table 5 shows the distribution of assets by industry for smaller corporations. (Presumably total firm assets will be larger than equity capitalization, since firms have some debt and may grow over time; date are shown for asset classes of $50 million and $100 million.) Despite the restrictions on the types of firms that are eligible, half or more of the assets of these firms are in trade and services.

 TABLE 5: DISTRIBUTION OF GROSS ASSETS BY INDUSTRY, SMALL CORPORATIONS

OTHER ISSUES

Three other issues that are relevant to the evaluation of the small business subsidies but that have not been addressed are distributional issues, administrative concerns, and the notch problem.

DISTRIBUTIONAL ISSUES

To some extent, the tax subsidies provided to small businesses will tend to reallocate resources and drive down the rate of return before tax. In this case, the benefits of the tax reduction will tend to be shifted in part, probably to ownership of capital in general. Some of the benefits would, however, accrue to the owners of small business.

The benefits will tend to accrue, in either case, to higher- income individuals. Brown, Hamilton and Medoff explore the income and asset positions of owners of small business with other owners of capital and with average individuals in the economy. ¹³ Families that owned small businesses were found to have eighty percent more income and over five times the wealth of the average family. Their wealth is similar to that of stockholders in large corporations. In general, the top 10 percent of households by wealth own about 80 percent of both types of businesses. The incomes of small business owners tend to be somewhat below that of owners of corporate stock -- the top 2 percent of households with highest incomes own 70 percent of large firms and 45 percent of small firms. (The authors note, however, that there are questions about the accurate reporting of income by small businesses). But it is clear that owners of small business have higher incomes than average.

To the extent that benefits accrue directly to owners of small businesses, they will be concentrated in a small group. According to the Statistics of Income 1985, individuals reporting an investment credit on their tax return accounted for only five percent of taxpayers.

ADMINISTRATIVE ISSUES

Whenever a tax provision for business is limited by size, it tends to create some serious administrative problems. One such problem is the treatment of multiple ownership of firms. If an individual or firm can split up business interests among different entities (partnerships or corporations) then he could qualify for the small business benefit. Such qualification might also be obtained by setting up leasing firms. To prevent these types of tax sheltering activities, it is necessary to set up a series of attribution and tracing rules that will place a burden on the Internal Revenue Service, and which are unlikely to work perfectly. These provisions are particularly difficult when considering minority interests in partnerships and corporations.

Another problem associated with the investment credit, which is based on size of receipts, is that taxpayers will have an incentive to arrange the timing of receipts and investments in order to qualify. For example, a firm would try to arrange to have large purchases occur in years when receipts are lower, or to delay or speed up receipts when a large purchase is planned. Firms have varying degree of control over their receipts, but firms on a cash basis might find such arrangements quite feasible.

The targeted capital gains relief presents some particular problems, in addition to the multiple-ownership problems. Certain businesses are excluded from coverage and there will likely be disputes over how to classic businesses. The IRS, in enforcing the provision, will have to deal with individuals selling stock that they may have bought many years in the past and determining that the corporation qualified throughout the holding period. There must also be safeguards to prevent current corporations from redeeming shares and reissuing them to qualify for the tax relief.

NOTCH PROBLEMS

Both provision have what is known as a notch problem. Because firms lose all benefits when receipts or assets rise above the limits, there is an enormous disincentive for production or investment above that level. This disincentive will cause its own inefficiency problems and discourage small firms from growing past a certain point.

The notch problem could be relieved by a phaseout of the provision, but a phaseout tends to be more costly and also creates disincentives for marginal investment throughout the phaseout range.

[Appendix omitted]

² See Jane G. Gravelle, Incremental Investment Credits, Congressional Research Service Report 93:209 S, February 10, 1993.

³ From the transcript published in the Washington Post, February 18, 1993.

⁴ U.S. Treasury Department, Summary of Administration's Revenue Proposals, February 25, 1993.

⁵ David Birch, Who Creates Jobs? Public Interest, V. 65, Fall 1981, pp. 3-14.

⁶ Catherine Armington and Majorie Odle, Small Business -- How Many Jobs, The Brookings Review, V. 1, No. 2, Winter 1982, pp. 1-4.

⁷ Charles Brown, James Hamilton, and James Medoff, Employers Large and Small, Cambridge: Harvard University Press, 1990.

⁸ John Case has argued that the Armington-Odle criticism is not correct but does not elaborate on the issue. See his book, From the Ground Up: The Resurgence of American Entrepreneurship, New York: Simon and Schuster, 1992 and his article, The Disciples of David Birch, in INC, January 1989, pp. 39-45.

⁹ To use an example, during this century there was a massive contraction in the share of employment in agriculture and accompanying growth in other types of employment. This shift in employment shares did not, however, mean that agriculture was less efficient. Indeed, it was the consequence of enormous technological progress in agriculture, through mechanization and other technical advances, that allowed fewer labor resources to be devoted to farming.

¹⁰ These issues are discussed in more detail in Jane G. Gravelle, Donald W. Kiefer, and Dennis Zimmerman, Is Job Creation a Meaningful Policy Justification? Congressional Research Service Report 92-697 E, September 8, 1992. This study also suggests that the government might wish to intervene to help disadvantaged workers.

¹¹ A recent study by J. Bradford De Long and Lawrence Summers (Equipment Investment and Economic Growth, Quarterly Journal of Economics, v. 106, May 1991, pp. 445-502) reported a positive relationship between growth rates and investment in equipment in different countries. In subsequent discussions, these authors suggest that equipment investment may result in certain externalities in worker skills (e.g., "learning-by-doing"). The examples of this spill-over effect are usually associated with manufacturing processes. Conventional growth theory holds, however, that there is no relationship between the level or allocation of capital and the growth rate in either the short or the long run, regardless of whether there are spill-over effects. From their data for developed countries, it appears that the relationship they found is the result of a few observations in a very small sample; such relationships do not hold up for more limited geographical areas. Alan J. Auerbach, Kevin A. Hassett, and Stephen D. Oliner find that the relationship for developed countries does not hold up when reasonable adjustment are made in the definitions of qualifying countries (Reassessing the Social Returns to Equipment Investment, Board of Governors of the Federal Reserve, Economic Activity Working Paper 129. December 1992).

¹² See Brown, Hamilton, and Medoff, Employers Large and Small, pp. 10-11, for a discussion.

¹³ See Brown, Hamilton, and Medoff, Employers Large and Small, pp. 4, p. 15-17.