From the Wall Street Journal

SEPTEMBER 18, 2010

When Big Business Enjoys Being Small

By JOHN D. MCKINNON

Republicans have been making hay with the argument that raising taxes on higher earners will harm small businesses. Now Democrats are countering that many of the businesses that fall into that category aren't really so small at all.

When they listen to Republicans, "most people are thinking about mom-and-pop businesses," Rep. Chris Van Hollen of Maryland, the head of the House Democratic campaign, said in an interview Friday. But he and other Democrats cite such high-profile names as Bechtel Group Inc., Kohlberg Kravis Roberts & Co. and PricewaterhouseCoopers as companies that also happen to fit under that umbrella.

For their part, Republicans say Democrats are trying to use a few extreme examples to divert attention from the fact that they want to raise taxes on many small businesses starting next January.

"The bottom line is that Washington Democrats' tax hike would hit 750,000 small businesses across the U.S.," said Michael Steel, a spokesman for House Republican leader John Boehner.

Who is right? Both sides' arguments are basically true. But they give only incomplete glimpses of a complicated landscape, one that has changed over the last 30 years as companies organized as small businesses have become far more numerous and successful.

The issue is coming to a head as Congress is debating what to do with the expiring Bush-era tax cuts. Democratic leaders and President Barack Obama want to preserve current tax levels only for families making less than $250,000.

Republican lawmakers, along with some Democrats, want to extend current tax levels for everyone, including higher earners. They say raising taxes in the top two brackets would hit small businesses hard. That's because taxes on small-business profits typically are paid through their owners' individual tax returns, and a large proportion of small-business income falls into the top tax brackets, they say.

Unlike large companies that pay corporate income taxes, small businesses typically are organized as "pass-through" entities, meaning they don't pay taxes themselves, but instead pass the income through to their owners. They include partnerships, Subchapter S corporations and limited-liability companies.

Republicans cite studies showing roughly half of all such income would be affected by raising the top two rates. Democrats say only about 3% of households reporting such income account for that half. That suggests much of the income comes from big businesses operating under small-business structures, they say. Businesses affected by the top tax rates include all sorts of concerns, from farms and manufacturers to high-tech and professional firms.

That trend has been under way for years. Congress authorized Subchapter S corporations in 1958 to encourage the growth of small companies. The popularity of pass-through entities grew in the 1980s with the lowering of individual tax rates and other rule changes.

By now, "the vast majority of employers in this country are organized as flow-throughs," said Brian Reardon, executive director of the S Corporation Association, which represents such companies.

Proponents say the proliferation of such businesses has freed up capital for investment by reducing overall taxation of corporate profits.

Critics say the rise of untaxed corporations is giving companies set up as small businesses unfair advantages.

But the new-found importance of such enterprises—regardless of their size—means raising individual tax rates could have significant economic impacts. This week, Moody's Economy.com said raising taxes on higher earners would reduce GDP by 0.4 percentage point in 2011, while payroll employment would be 770,000 lower by mid-2012.

Alan Viard of the conservative American Enterprise Institute said the two parties miss the point by focusing on small businesses, because firms of all sizes contribute to national prosperity.

"The Democratic response from an economic perspective is irrelevant," he said. "But the Republicans have invited this by labeling it as a small-business issue."