CRS Evaluates Small Business Tax Benefits: Current Law and Arguments For and Against Them

Posted by Kim Chen on August 24th, 2018

A recent Congressional Research Service (CRS) report examines the concept of small business tax benefits, lists what it considers the major small business tax benefits that have a general application, and analyzes what it considers the main arguments for and against federal support for small business.
Small business tax benefits, generally. The federal tax burden on small firms and its effects on their formation and growth have long been matters of legislative concern for Congress. This abiding interest has helped pave the way for the enactment a series of tax laws in recent years that included targeted tax relief for a number of small businesses. A recent estimate by the Joint Committee on Taxation suggests that the cost of this relief might exceed $17 billion in FY2018.
Small business tax benefits (or preferences) raise three potential policy issues for Congress. First, what is the appropriate definition of a small business in the context of public policy?
Second, is there a sound economic justification for supporting small firms? If no such rationale can be found, then government support for small businesses may do more harm than good by distorting the allocation of domestic economic resources.
Third, are tax benefits the most cost-effective way for the federal government to assist small firms? Small business tax preferences entail the following economic costs:
1. The foregone revenue and any interest charges from federal borrowing to offset that revenue loss,
2. The resources required to comply with the rules governing the use of the tax benefits and to enforce compliance with those rules, and
3. The opportunity cost of the foregone revenue and the resources devoted to tax compliance and enforcement.
The small business tax benefits examined by CRS. CRS listed and analyzed the effects of the following small business tax benefits:

• Expensing allowance for machinery and equipment under Code Sec. 179;
• Cash-basis accounting under Code Sec. 446;
• Tax credit for a portion of the costs incurred by small firms in establishing pension funds for employees under Code Sec. 45E;
• Tax credit for costs incurred by small firms in complying with the Americans with Disabilities Act under Code Sec. 44;
• Full exclusion from the capital gains tax on the sale or exchange of qualified small business stock under Code Sec. 1202;
• Exemption from the limitation on the deduction for business interest expenses under Code Sec. 163;
• Tax credit for small firms that offer qualified health insurance coverage to employees under Code Sec. 45R;
• Simplified dollar-value last-in-last-out accounting under Code Sec. 474;
• Deduction for and amortization of business start-up expenses under Code Sec. 195;
• Ordinary income treatment of losses on the sale of certain small business stock under Code Sec. 1244;
• Treating losses on the sale of Small Business Investment Company stock as ordinary losses under Code Sec. 1242;
• Exemption from the uniform capitalization rule under Code Sec. 263A; and
• Use of research tax credit to reduce payroll tax for certain small firms under Code Sec. 41.
The report notes that, as a result of the enactment the Tax Cuts and Jobs Act (P.L. 115-97, 12/22/2017; TCJA), the current lineup of small business tax benefits differs somewhat from the 2017 lineup. Under previous tax law, the graduated corporate income tax (whose rates ranged from 15% to 35%) was considered a small business tax benefit. The TCJA permanently replaced those rates with a single corporate tax rate of 21%, starting in 2018. The TCJA also repealed a second small business tax benefit: the rollover of gains from the sale of publicly traded securities into specialized small business investment companies under former Code Section 1044. In addition, by repealing the corporate alternative minimum tax (AMT), the TCJA also did away with another small business tax benefit: an exemption under former Code Section 55(e) from the AMT for corporations whose average annual gross receipts did not exceed $5 million in their first three tax years and $7.5 million in each succeeding 3-year period.
Observation: The Code Sec. 199A qualified business income (pass-through) deduction, that is effective for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026 under the TCJA, is not included in the CRS report list.
Arguments for and against federal support for small business. The report lists the following arguments in favor of government support for small business:

1. The special economic role played by small firms. Small firms generate uniquely valuable economic benefits. These benefits can be seen in the multitude of jobs and new technologies small firms create over time, their innumerable and ever-changing linkages to larger firms in supply chains, and their unique contributions to economic renewal and growth. Proponents maintain that the net effect of these activities is to accelerate the growth of the U.S. economy in ways that large firms cannot.
2. The financial barriers to their formation and growth.
3. The impact of relatively high marginal tax rates on the formation and growth of small entrepreneurial firms.
4. The unique opportunities for individual economic advancement created by small business ownership.
The report also makes arguments against tax benefits for small businesses. It notes that a key element of standard economic analysis is that government intervention in the economy is warranted mainly to remedy a market failure. In general, such a failure represents a condition that prevents or hinders the emergence of economically efficient outcomes. Foremost among the market failures identified by economists as justifications for government intervention are:

• Lack of perfect competition,
• Presence of public goods,
• Positive or negative external effects (or externalities),
• Incomplete markets, and
• Imperfect or asymmetric information on the part of key economic agents.
Critics of government support for small businesses say there is no evidence that a market failure is affecting (or has affected) trends in small business formation, growth, investment, and failure. More specifically, they can find no evidence that imperfections in financial markets are leading to the formation of too few or the failure of too many small firms, or that small firms in general generate uniquely valuable positive externalities. Therefore, say critics, in the absence of a verifiable market failure, government support (including tax subsidies) for small business seems unwarranted on economic grounds.

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