Who'd get hit with a tax hike: small business or the rich?

Most of the businessmen in the two top income brackets are not the lawyer or corner grocer who files Schedule C.

Howard Gleckman discussed some of the facts and issues regarding the role of small businesses in the debate on the expiring 2001 and 2003 tax cuts. Eric Toder expressed a strange sense of déjà vu.

While everyone agrees that changes in the top two marginal tax rates would affect only a small share of individuals who report business income on their tax returns, proponents of full extension point out that those high-income individuals receive a large fraction of net positive business income. (JCT has estimated that fraction at 50 percent; TPC’s estimate is closer to 45 percent.)

But what is less well known is what that business income consists of. How much represents the income of the neighborhood grocer or the owner of a small manufacturing firm? And how much represents the income of highly-paid professionals who take their income in the form of partnership shares, such as partners in law firms, accounting firms, and Wall Street hedge funds?

While the exact source of business income reported on tax forms cannot be determined, TPC recently released estimates that provide some additional information on the sources and distribution of flow-through business income which may yield further insights about the potential effects of allowing the top two tax rates to return to their pre-2001 levels.

The narrowest measure of small business income is that which is reported by nonfarm sole proprietors (on Schedule C of the IRS Form 1040). These would include the self-employed and many people running truly small family businesses, like the proverbial corner grocery store, but also would include some independent professionals (doctors, lawyers, independent consultants). The potential impact of raising the top two rates on these independent business owners is considerably smaller than the impact on taxpayers reporting business income from other sources.

TPC estimates that fewer than 250,000 taxpayers, about 1.5% of tax units reporting positive Schedule C income, will fall within the top two income tax brackets in 2011. These high-income taxpayers will report $38 billion in income—just over 11 percent of total positive sole proprietor income and only about 4 percent of all flow-through business income.

The vast majority of business income reported by taxpayers in the top two tax brackets comes from partnerships and S corporations and these taxpayers report most of the net positive income from these sources ($400 billion, or nearly 63 percent of net positive income from such businesses). Not surprisingly, that income is also highly skewed within the top bracket.

For example, just 17 percent of the $133 billion of partnership income in the top bracket goes to business owners reporting less than $500,000 of income, and 46 percent goes to those reporting less than $1 million. Income from S corporations is even more concentrated—64% of the $211 billion subject to the top rate is for owners with more than $1 million in income.

What do we know about the types of businesses that are generating these large incomes? Unfortunately the answer is not as much as we would like. Individual returns provide very little information about the underlying businesses and the IRS does not release any firm-level data to the public.

A 2008 JCT study (see Table 8a) reports that 61 percent of net income from partnerships and S corporations is earned by firms with gross receipts over $10 million and fully 43 percent by firms with gross receipts in excess of $50 million. Those data suggest that the majority of affected income may not come from what we generally think of as a small business, although we do not know whether large and small firms differ in how they distribute income among taxpayers in different income groups.

A recent open letter from a number of prominent academic economists called for better access to U.S. government data for research purposes. Allowing researchers access to micro-level data on flow-through business returns would result in a better understanding of the key economic and behavioral responses central to this policy debate.

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