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The Small Business Distortion

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Here's an important lesson for anyone watching state or federal tax policy debates: just because elected officials say they're doing something for "small businesses" and "job growth" doesn't mean that they really are.

A good example comes from North Carolina, where the legislature last year passed a business tax break that is taking $336 million a year away from public schools, health care, child care, and other state-funded services. As the Raleigh News & Observer recently wrote:

[Legislators] heralded the tax break as a "$50,000 exemption for small businesses -- the backbone of North Carolina's struggling economy." But the exemption is not just for small businesses. There is no cap on the size of the business that can claim the exemption. So the break will go to roughly 460,000 business owners of all sorts, including equity partners in law firms, doctors and dentists with thriving practices, even lobbyists who patrol the legislature. It also includes some state lawmakers who are business owners.

The Charlotte Observer chimes in: "It's no wonder some recipients of the tax break are backing away from it."

South Carolina lawmakers are considering a similar tax break, and earlier this year, Kansas enacted one that is even more fiscally irresponsible (and no more economically justifiable) than North Carolina's. As University of Kansas tax law professor Martin B. Dickinson wrote, the change will "shift ... the income tax burden from the wealthy and prosperous to working people."

What it won't do is target small businesses, much less those small businesses that are likely to create jobs, as we pointed out earlier this year.

In fact, nationwide data show that only a small fraction of the income from firms organized as "pass-through entities" -- the kind of income eligible for the North Carolina, South Carolina, and Kansas tax breaks -- is from small, job-creating businesses.

There's an important lesson here for federal policymakers, too. Supporters of extending President Bush's tax breaks for household incomes over $250,000 point out that some of those tax breaks go to people who own small businesses. But, as Kelly Conklin, a small business owner in New Jersey, notes, such well-heeled small business owners are the exception -- not the rule. Citing our research, he points out:

A mere 3 percent of American taxpayers who report business income of any kind (let alone from a real small business) earn above the $250,000 threshold. Oh, and about that 3 percent figure: it includes the likes of hedge fund managers, partners in major law firms, best-selling authors, even K Street lobbyists. Take those high earners out and how many real small business owners will be left? Only a tiny fraction.