CBO: Regulations, Taxes Can Hurt Small Businesses

Matt Cover | March 15, 2012 | 6:13pm EDT
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(CNSNews.com) – Federal regulations and tax policy can harm small businesses or discourage them from expanding in a bid to avoid the higher regulations and taxes that the government levies on larger firms, according to the Congressional Budget Office.

A CBO report published March 12 examines the job-creation records of small businesses and the federal regulatory and tax environments they face. It finds that small businesses create more jobs faster than their larger counterparts, but often face pressures arising from federal tax and regulatory policy.

“The ability of all firms to expand or become more efficient – that is, to produce goods and services in a more cost-effective way – is influenced by federal policies that determine the taxes those firms pay, the availability of credit, the regulations with which they must comply, and other factors,” the CBO said.

Those policies, particularly taxes and regulations, can have a large impact on how small firms operate and whether they are able to grow or not. Because the federal government imposes much harsher tax and regulatory policies on larger businesses, small businesses may elect to stay small to avoid being penalized.

“[A] disadvantage of policies favoring small firms is that such policies may inadvertently discourage certain firms from increasing in size and losing that preferential treatment.”

On of the ways that government policy can impact small business is through the tax code. The CBO explained that the vast majority of small businesses are known as pass-through entities, meaning that the income earned from business activities is assumed to pass through to the personal finances of the owner.

Because of this, government taxes these small businesses at individual income tax rates, not corporate tax rates. This means a small business can face higher taxes if it outgrows pass-through status.

“Tax policies can significantly affect decisions about whether to start a new business or to expand an existing firm,” the report said. “In addition, large and small businesses tend to choose different organizational structures – a choice that has tax consequences that may or not be advantageous to small businesses.”

The CBO said that for small businesses that can invest their owners’ own funds, pass-through status provides an advantage because the investment can be written off, resulting in a lower tax rate. However, for small businesses that need outside financing – such as a bank loan – to invest, pass-through status can hurt them because they cannot write off the investment, making their taxes go up.

Regulatory policy can also affect small businesses. Many small firms are exempt from federal regulations dealing with civil rights and environmental laws. This regulatory ceiling means that firms starting out small may remain that way to avoid the compliance costs of increased federal regulations.

“[C]ompliance with federal regulations – such as those aiming to prevent discrimination or reduce pollution – often requires that firms develop internal systems or procedures that have a fixed cost per firm in addition to costs that vary with the size of the firm. In that case, achieving the goal of the regulation at small firms will be relatively more costly than achieving it at large firms.”

The upside of favoring small business through tax and regulatory policy is that small businesses generally create jobs faster than large businesses do, creating a trade-off for the federal government.

“Therefore, policymakers may reasonably decide to apply certain regulations in modified form at small firms or to exempt small firms from some regulations altogether,” the CBO said. “Such an approach could promote employment growth.”

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