Flat tax fails to help small businesses – favor high income companies

The most common argument cited to support flat income taxes and other measures that lower taxes for affluent families is that doing so will strengthen small businesses and accelerate economic growth within a state’s borders. Neither of these claims has merit.

Small businesses tend to be organized as sole proprietorships, partnerships, or S corporations and their owners pay tax through the personal income tax code rather than through the corporate income tax. But flat taxes tend to favor those with the highest incomes—including the largest and most profitable businesses rather than the smallest.

Unlike sales or property taxes, personal income taxes are only paid on net business profits and struggling businesses that are failing to turn a profit do not owe personal income tax regardless of whether the rate is flat or graduated. Moreover, under a graduated rate system the owners of small businesses generating only modest profits will tend to be in lower tax brackets than their larger and more profitable competitors. Very large companies like Koch Industries, Publix Supermarkets, Fidelity Investments, and countless law firms, lobbying shops, and real estate firms are organized as S corporations or partnerships and see their profits taxed under the personal income tax code. A well-designed graduated rate tax can tax partners and shareholders at more profitable firms at a higher rate than mom and pop shops.

Some flat tax proponents also make sweeping claims that cutting tax bills for the owners of profitable businesses through flattening the income tax will spark faster economic growth. But the ability of state lawmakers to affect business decisions through rewriting the personal income tax code is sharply limited by the small overall size of these taxes. ITEP recently calculated that state and local taxes account for just 2.3 percent of the cost of doing business, with the other 98 percent tied up in other areas like payroll, equipment, and real estate costs.[5] Moreover, according to the accounting firm Ernst & Young LLP, state personal income taxes make up just six percent of the total state and local tax bill falling on business.[6] The personal income tax is a small fraction of a small fraction of the expenses paid by business owners, suggesting that even dramatic changes in this area will have minimal impact on businesses’ bottom lines.

Finally, some defenders of flat taxes argue that repealing top brackets can prevent high-income people from leaving a state. The best research to date in this field, however, has shown that income tax levels have little impact on where the wealthiest taxpayers choose to live and that, in fact, the millionaires who stand to gain the biggest tax cut from the switch to a flat tax are already less inclined to move across state borders than other families.[7]