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Lowering Taxes on Manufacturers Won't Help Small Business (Opinion) Giving special treatment to one industry leads to misallocation of resources to that favored business sector.

By Scott Shane Edited by Dan Bova

Opinions expressed by Entrepreneur contributors are their own.

President Obama wants to help American manufacturers by allowing them to pay lower taxes than other businesses. His tax reform plan sets a maximum corporate rate of 28 percent, but proposes a maximum rate of only 25 percent on manufacturers, and even less if the business qualifies as "advanced" manufacturer -- a term that the President's proposal fails to define.

His plan is bad economic policy and is particularly bad for small-business owners.

Economists generally believe the tax system should treat all industries equally. Giving special treatment to one industry leads to misallocation of resources to that favored business sector. The administration seems to agree, at least when discussing the incentives the tax code currently creates for overinvestment in oil and gas drilling. The President's Framework for Business Tax Reform states, "Currently, tax expenditures in the tax code vary dramatically by industry. ... The result is a tax system that distorts investment decisions."

Yet in the same document, the White House argues that we should create a new distortion by allowing manufacturers to pay lower taxes than other businesses. Perhaps I haven't spent enough time learning "Washington economics" because I am left wondering: If the current tax code creates distortions because it favors one industry over another, then how does changing the tax code to favor another industry do anything other than produce new distortions?

Related: Four Ways to Write Off Health-Care Expenses (Video)

The Obama administration argues that manufacturers deserve special treatment because they conduct more research and development, making them more innovative than other industries. As the President's Framework argues, "Manufacturing contributes disproportionately to U.S. innovation; manufacturing firms conduct more than two-thirds of the private sector research and development (R&D) in the United States and employ the majority of scientists and engineers in the private sector." Investment in manufacturing, therefore, is more beneficial to the economy than investment in other sectors, the President's team argues.

But there is little consensus among mainstream economists that manufacturing is special. In an opinion piece in The New York Times, Christina Romer, the President's former chief economic advisor who is now a professor at the University of California at Berkeley, said there is no evidence that expansion by manufacturers provides greater benefit to the economy than expansion by any other businesses.

The President's plan for a lower corporate tax rate on manufacturers does little for small business because it helps only manufacturers that are set up as C corporations. Most small businesses are structured as pass-through entities -- sole proprietorships, partnerships and Subchapter S corporations. As the National Association of Manufacturers, which represents companies in the industries with the most to gain from the President's plan, said in response to the proposal, "The two-thirds of manufacturers who file as individuals will receive no relief from the current burdensome tax system."

Related: Senate Offers Its Own Small-Business Tax-Cut Plan

Favoring manufacturers over other industries is problematic for small businesses in other ways, as well. First, small business is underrepresented in manufacturing. The latest available data provided by the Office of Advocacy of the Small Business Administration shows that manufacturers account for 22 percent of large companies but only 5 percent of small ones.

Second, the plan will encourage businesses to try to be reclassified as manufacturers -- or "advanced" manufacturers if they can -- a process almost certain to favor big companies. We all know that big companies, with their large staffs of lawyers, accountants and consultants, will be more successful in getting reclassified. Small-business owners are too busy running companies to spend much time on economically unproductive paperwork.

Rather than proposing tax plans to benefit his favored industries, the President would be better off suggesting ways to help all small businesses. In case White House economists haven't yet noticed, another arm of the Obama administration -- the Small Business Administration -- notes that small businesses "employ about half of all private sector employees" and account for "more than half of the nonfarm private GDP."

Related: Three Tips for Maximizing the Meals Write-Off (Video)

Scott Shane

Professor at Case Western Reserve University

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).

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