	Introduction

Some lawmakers have expressed concern over the impact on small business of several proposed increases in the income tax rates for high-income individuals being considered in the current Congress. Upper-income individuals would also face higher marginal tax rates under the versions of health care reform legislation passed by the House ( H.R. 2786 to H.R. The House measure would impose a surtax equal to 5.4% of modified adjusted gross income (MAGI) in excess of $500,000 for single filers and in excess of $1 million for joint filers. Proponents of the proposed rate hikes say they are needed to raise revenue for a variety of crucial budgetary purposes (including reducing projected federal budget deficits). In their view, the hikes would also reverse the decline in the progressivity of the individual income tax ushered in by the sweeping tax cuts enacted during the Bush Administration. Using a micro-simulation model, economists at the Tax Policy Center (TPC) jointly managed by the Urban Institute and the Brookings Institution have generated a distribution of small business income and filers with such income by tax bracket for 2007 and 2009. Still, a line must be drawn between small business income and all other sources of income in order to determine the share of small business owners and small business income that could be affected by an increase in the marginal tax rates affecting upper-income individuals. In both cases, such an owner is anyone who reports any income or loss on Schedule C (self-employment income), Schedule E (income from rents, royalties, partnerships, limited liability companies, and S corporations), and Schedule F (farm income). On the other hand, the definition has several limitations that call into question its usefulness for policy analysis. So given the limitations of any distribution of small business owners and income by tax bracket that relies on the TPC/Treasury definition, its results should be viewed as illustrative or suggestive rather than definitive or conclusive. Less than 2% of tax filers in those brackets in both 2007 and 2009 reported any small business income. Thus, it seems reasonable to conclude that even after allowing for the limitations to the measurement of small business income in the TPC analysis, a tiny share of individual taxpayers who own and are actively involved in the management of firms that many would regard as small on the basis of their employment, revenue, or asset size would be affected by an increase in the top two individual tax rates. Finally, the results suggest that the proposed tax hikes for upper-income individuals would affect a greater share of small business income than small business owners. In 2007 and 2009, small business income represented an average of 30% of AGI for filers in the 33% tax bracket, and an average of 35% of AGI for filers in the 35% bracket; by contrast, the average for all taxpayers (including non-filers) was 14%. For the third scenario, the individual rate stays at 39.6% and the corporate rate at 35%, but the capital gains rate rises to 20% (as proposed by the Obama Administration for 2011 and beyond). The distribution of taxable income among the main forms of business organization can affect the amount of revenue flowing into the U.S. Treasury. Small Business Formation and Investment

Federal tax policy has the potential to affect the performance of small firms through its impact on the incentives for savings, investment, and entry into self-employment. Critics of the proposed increases in the marginal tax rates for high-income taxpayers claim they would harm the domestic climate for small business formation and investment. The availability of investment tax incentives and other business tax benefits may lessen or offset the dampening effect of such a rise.
Some lawmakers have expressed concern over several proposals being considered in the current Congress to raise the tax burden on high-income individuals. Of particular concern are a proposal by the Obama Administration to allow the top two individual marginal tax rates (currently 33% and 35%) to return to their pre-2001 levels of 36% and 39.6%, starting in 2011, and a provision in the health care reform bill passed by the House (H.R. 3962) to impose a 5.4% surtax on the modified adjusted gross incomes (MAGIs) of single filers above $500,000 and the MAGIs of joint filers above $1 million, also starting in 2011. Critics claim the proposed tax hikes would undermine the economic incentives for small business formation and investment.
By contrast, backers of the Administration's proposal say it is needed to raise revenue during a time of large budget deficits, inject greater progressivity into the federal income tax in the wake of the sweeping tax cuts enacted during the Bush Administration, and promote a fairer distribution by income level of the cost of government services. A similar argument underlies support for the surtax in H.R. 3962.
One approach to evaluating the contention that the proposed tax hikes would harm small business investment, formation, and growth is to examine the distribution of small business income and the tax returns of small business owners by tax bracket. Two critical considerations in undertaking such an evaluation are the definition of small business income and ownership and its compatibility with available federal income tax data.
An analysis by the Urban Institute-Brookings Institution Tax Policy Center (TPC) of the distribution of small business income and tax filers reporting such income by tax bracket in 2007 and 2009 defines a small business owner as anyone who reports income or loss on Schedule C (self-employment income), Schedule E (income from rents, royalties, partnerships, limited liability companies, and S corporations), and Schedule F (income from farming). Such a broad definition arguably has more disadvantages than advantages, calling into question its usefulness for policy analysis. So any results based on such a definition should be seen as illustrative or suggestive rather than definitive or conclusive.
The TPC analysis found that a small share of small business owners would likely be affected by the proposed tax hikes: an average of less than 2% of such individuals were subject to the 33% or 35% marginal tax rates in 2007 and 2009. At the same time, the results suggested that a significant share of small business income could be subject to the higher rates. In 2007 and 2009, small business income represented an average of 30% of adjusted gross income (AGI) for filers in the 33% tax bracket, and an average of 35% of AGI for filers in the 35% bracket; the average for all filers was 14%.
Raising the marginal tax rates facing high-income individuals without changing the top corporate or capital gains tax rates in theory could increase the share of firms organized as C corporations rather than passthrough entities. A shift in the distribution of taxable income among the main forms of business organization might have a significant impact on business tax revenue.
A rate hike also has the potential to harm the domestic climate for small business formation and investment. But current business tax benefits, if retained beyond 2010, would lessen a rate hike's dampening effect on investment, and its impact on the creation of new firms may be difficult to determine.