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The Bush tax cuts and small business

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Alex Brandon/AP

(Read caption) Senate Minority Leader Mitch McConnell of Ky., center, with, from left, Craig Fritsche, Sen. Lamar Alexander, R-Tenn., Pat Felder, Phyllis Burlage, Sen. Johnny Isakson, R-Ga., talks about the tax burden on small businesses during a news conference on Capitol Hill in Washington Wednesday, Aug. 4. The debate over whether letting the Bush tax cuts expire will likely continue through the fall.

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Those who would extend all of the Bush tax cuts, including for the highest-earners, are zeroing in what would happen to small business if Congress lets those top tax rates rise. And they are not subtle. Allowing top rates to increase would be a “job-killing tax hike” says Senator Orrin Hatch (R-Utah).

So let’s take a closer look at these firms and what higher taxes might mean both for them and the overall economy.

This is what we know: Most small businesses report their income on individual tax returns, either on Schedule C (for self-employment or sole proprietorships), Schedule E (for S corporations) or schedule F (for farms). We don't know how many of these businesses are really small, but next year about 36 million taxpayers will report income from these sources on their 1040s. Only about 900,000, or 2.5 percent, would pay higher rates if the Bush tax cuts were allowed to expire for those in the top brackets. However, that relative handful of business owners will report $400 billion, or almost 44 percent of all the business income included in individual returns.

The average positive business income reported on 1040s is less than $40,000. If this was their only income, an average business filer would be miles from the top two tax brackets. Obama would continue the tax cuts for individuals making $200,000 or less and couples making $250,000 or less. A single filer who has only business income and makes the average of $40,000 would have to see his profits rise five-fold before he’d be hit by higher tax rates.

But for many of those reporting positive business income, these earnings are a relatively small fraction of their total taxable income. Some may be earning a little something from a side business. Perhaps they own a piece of rental property. Or do a bit of baby sitting. Some may be plumbers or computer technicians who work a day job and pick up a few extra bucks after hours, or corporate accountants trying to start a cupcake business in their free time.

On the other hand, some reporting business income would face higher taxes if the top rates returned to their pre-2001 levels of 36 percent and 39.6 percent, up from today's 33 percent and 35 percent. Ninety percent of high-earners who receive business income will get at least half of their AGI from this source in 2011. A half million top-bracket filers will report net positive business income averaging more than $700,000. These are the people--not the mom-and-pop business owners-- who would be hit by the expiration of the top bracket tax cuts.

Who are they? Many are doctors, lawyers, and investors. Others are very successful entrepreneurs who may own a chain of grocery stores or dry cleaners, or a lot of real estate. Do they fit your image of a small business owner? That, I suppose, is in the eye of the beholder.

And now to the bottom line: Would raising their taxes be a job-killer? That is less clear. Some research suggests that higher tax rates actually encourage small business formation. Why? Because these firms allow their owners to shelter lots of income, behavior that is more lucrative when rates are higher. Other research suggests that higher rates do retard investment and hiring by existing firms. Donald Bruce and Tami Gurley-Calvez, who study small business for the Hudson Institute, have written a nice review of all these issues.

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While we are not certain about what higher taxes will mean for small business, we know these firms will suffer if they are unable to access capital. And to the degree that ever-greater government borrowing makes it harder for these firms to raise money, they and their employees will pay a price. That is the other consequence of keeping taxes low for high earners, which will cost nearly $700 billion over the next decade.

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