Representative Paul Ryan (R-Wisc.) hinted recently that he intends to introduce tax reform legislation to the U.S. House of Representatives in the first quarter of 2014. While we don't know yet exactly what Mr. Ryan plans to propose, let's hope that he's planning to call for more than just the corporate tax reform that President Obama suggested earlier this year. Our economy and our sense of fairness both demand it.
Corporate tax reform makes sense. America's corporate tax rate is the highest in the developed world, a situation that hinders American competitiveness. Our corporations waste huge sums of money to comply with a maddeningly complex tax code. They face strong incentives to spend their money unproductively, hiring accountants and lawyers to reduce their tax expenditures rather than to boost profits by hiring additional workers and making capital investments. Finally, our high corporate tax rate encourages multinational corporations to park their profits overseas where taxes are lower, rather than repatriate them to the United States, where they can contribute more to domestic economic growth and job creation.
But corporate tax reform alone is an insufficient goal. Broader tax reform is necessary to boost economic growth and job creation. Corporate tax reform fails to address the problems small business owners face with a complex and inefficient tax code because three quarters of them are structured as "pass-through entities" - partnerships, sole proprietorships, limited liability companies, and S-corps that pay taxes as individuals, not as corporations. Moreover, the majority (54 percent) of business income is earned by pass-through entities, the Tax Foundation reports. With small businesses accounting for half of private-sector employment and contribution to GDP, failure of tax reform to affect small company owners will mean that its effects on economic growth and job creation will be muted.
Broader-than-just-corporate-tax reform would also be fairer. Because most small businesses are pass-through entities, they generally face higher marginal tax rates than larger businesses, which are structured as corporations. Moreover, this difference would widen considerably if the corporate tax rates were cut, hitting 14.5 percent if the corporate tax rate were reduced to 25 percent as some have proposed. Requiring businesses that produce the same profits through the same activities to pay different tax rates simply because of their business structure is simply unfair.
Washington risks raising the small-business tax burden if it focuses only on cutting corporate tax rates. Given our current budget deficit, policymakers face pressure to ensure the revenue neutrality of any tax-reform plans. If cutting corporate tax rates would reduce tax revenues, policymakers would face pressure to make up that revenue loss by boosting individual tax rates, or otherwise raise taxes on pass-through entities.
Our complex tax code imposes a heavier administrative burden on small companies than on large ones. Not only do small business owners lack an army of accountants and lawyers to find loopholes and deductions to cut their taxes, but also their tax-compliance costs are higher. Because of economies of scale, per-employee costs of complying with tax laws for companies with fewer than 20 employees are three times higher for small companies than with 500 or more workers the Office of Advocacy of the U.S. Small Business Administration (SBA) reports.
Small business owners and their advocates might would be wise to spend their time this holiday season preparing a message for Representative Ryan. If he cares about small business, his tax reform proposal should go beyond corporate taxes to address the problems that the tax code creates for Main Street.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.
Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).