	Introduction

At the end of 2010, the lower income tax rates provided in the 2001 tax cuts were to expire. President Obama had proposed to extend most of the income tax cuts, but to continue some higher tax rates for couples with income over $250,000 and singles with income over $200,000. The most important element of this proposal, as measured by revenue effect, is allowing the top two rates of 33% and 35% to expire. These rates would have risen to 36% and 36.9%. 111-312 extended all tax cuts for two years. Some critics of allowing the tax rates to rise express concerns about possible negative effects on small business owners' hiring and the dampening effect on job creation. This argument is buttressed by a popular conception that small businesses are responsible for the majority, perhaps the vast majority, of new jobs. Two aspects of targeting are considered: the fraction of small businesses affected by the rate changes and the fraction of revenue gain accruing to taxpayers other than these small businesses. The results suggest that only a small fraction of small businesses will be affected, around 2% to 3%. They also suggest that 80% of the reduced taxes are likely to accrue to non-businesses income and about 90% to non-business income or businesses without employees. The second section of the report reviews the claim that small businesses are the primary creators of jobs. This perception is based on research published originally in the 1980s. More recent research has revealed some methodological deficiencies in these original studies and suggests that small businesses contribute only slightly more jobs than other firms relative to their employment share. In addition, this differential is not due to hiring by existing small firms, but rather to startups, which tend to be small. The following section discusses perhaps the most important issue to consider, job creation as a policy justification for targeted provisions. The basic economics of market equilibrium indicate that, in the long run, there is no need for the government to intervene in the creation of jobs. In the short run, intervention is appropriate during a recession, but tax cuts to businesses and high-income individuals are not likely to be very effective for this purpose. First, self-employment offers greater opportunities to avoid or evade taxes, and avoidance and evasion are more valuable the higher the marginal tax rates. In general, research suggests that when using fiscal policy to stimulate the economy, direct spending and reducing taxes or increasing transfers to lower-income individuals is likely to be most effective. Other Justifications for Special Tax Provisions and Treatment of Small Business

As the findings in this report suggest, across-the-board tax cuts for high-income individuals are not efficiently targeted to small businesses. The second is whether there are justifications for favorable treatment. As well as lack of target efficiency, evidence on the role of small business in job creation, the effects of tax changes on small business behavior, and the likelihood this provision would not be an effective demand stimulus suggest that the formulation of small business policies should be informed and guided by any market failures that may exist.
At the end of 2010, the lower income tax rates provided in 2001 were to expire. The President had proposed to extend most tax cuts, but to continue higher rates for couples with income over $250,000 and singles with income over $200,000. The most important element of this proposal, as measured by revenue effect, is allowing the top rates of 33% and 35% to expire, when they would have risen to 36% and 36.9%. P.L. 111-312, enacted in December 2010, extended all tax cuts for two years, through 2012, delaying the consideration of which tax cuts to retain.
Some critics of allowing the tax rates to rise express concerns about possible negative effects on small business owners' hiring and the dampening effect on job creation. This view is buttressed by a popular conception that small businesses are responsible for the majority, perhaps the vast majority, of new jobs.
The first issue addressed is how well retaining the lower levels of the top two rates target small business. Two aspects of targeting are considered: the fraction of small businesses affected by the rate changes and the fraction of revenue gain accruing to taxpayers other than these small businesses. The results suggest that only a small fraction of businesses would be affected, around 2% to 3%. They also suggest that 80% of the reduced taxes are likely to accrue to non-business income and almost 90% to either non-business income or businesses without employees.
The claim that small businesses are the primary creators of jobs is based on research published originally in the 1980s. More recent research has revealed some methodological deficiencies in these original studies and suggests that small businesses contribute only slightly more jobs than other firms relative to their employment share. Moreover, this differential is not due to hiring by existing small firms, but rather to startups, which tend to be small. Some critics also question whether small business jobs should be encouraged because they tend to be lower paid, with fewer benefits and more turnover. Yet, small businesses may offer employment to workers with less education or other characteristics that lead to difficulty finding employment with larger firms.
In addition to targeting efficiency and job creation issues, there is uncertainty about the effects of taxation on small businesses. An extensive literature suggests that higher taxes have no effect or actually encourage self-employment. Researchers speculate that higher taxes may lead individuals to select self-employment because the opportunities for tax evasion and avoidance are greater. In addition, taxes reduce risk (the variance in return) and greater variance in earnings likely occurs in self-employment. Evidence of effects of taxes on existing firms' hiring is limited.
Perhaps the most important issue concerns job creation as a policy justification. In the long run, there is no need to address job creation as the market economy naturally generates jobs (although targeted programs, such as those for disadvantaged workers, may improve efficiency). In times of recession, the government may need fiscal stimulus, but the purpose of this stimulus is generally to increase aggregate demand. The most effective approaches are direct spending and tax cuts and transfers to lower income individuals who are more likely to spend. Tax cuts for high-income individuals or business are less likely to be spent and are less effective as a stimulus.
There may be justifications for favoring small business, although small businesses, especially businesses owned by high-income individuals, are already subject to favorable treatment. Tax policy might be most appropriately formulated in the light of any imperfections in the economy that justify preferential treatment.