Shed No Tax Tears for ‘Small’ Business : The ‘small’ business lobby is run by and for larger businesses; most truly small firms won’t be hit be a tax hike.

These days we all worship at the shrine of “small business.” In the debate about President Clinton’s budget, opponents argued that higher taxes on incomes of more than $180,000 would not just hit the affluent because “small businesses” pay taxes at personal income-tax rates. The Clintonites replied that the budget bill was filled with new goodies for small businesses. The question whether “small business” is deserving of all this solicitude did not arise.

Small business is an important part of the American economy. Most small-business owners are admirable, hard-working, patriotic. But the case for tilting public policy in favor of “small business” is based on fallacies and lobbyists’ hokum.

Fallacy No. 1 is that small businesses are run by “small” people. In fact, the typical owner of a Fortune 500 corporation is far less affluent than any small-business person affected by the Clinton tax increase. Most stock in large corporations is held by mutual and pension funds for the benefit of working and middle-class investors. By contrast, the only “small” business people hit by the tax hike are those with incomes of more than about $180,000. If a small business has more than one owner, each one must have income greater than $180,000 before the new taxes hit.

Only 4% of unincorporated (“small”) businesses are big enough to be touched by these higher tax rates. By contrast, more than half of all small businesses are really small. Their owners report income from all sources of less than $30,000. Most of these will qualify for Clinton’s expanded Earned Income Tax Credit. If your business philosophy truly is that “small is beautiful,” you should celebrate this new subsidy to truly small businesses. But the “small” business lobby is actually run by and for the benefit of larger businesses.

A favorite knee-jerk statistic of the 1980s was that small businesses create eight out of 10 new jobs. That turns out to be something of a myth--even the researcher who came up with it now renounces it. But even if small businesses are an especially fecund source of jobs, it does not follow logically that they deserve special treatment from the government. Asian-Americans are disproportionately productive. Would it make sense to give them a special tax break? No. Every tilt of the government toward one source of economic activity is a tilt against all others. Avoiding such tilts is not just a matter of fairness; it is a matter of letting the market decide. If the government is as neutral as possible, the market will reward small businesses or Asian-run businesses or any other kind of businesses exactly the right amount to maximize the output of all businesses.

“Small business” agitprop has it that higher taxes will be a disadvantage in competing with foreign companies and will force small businesses to hire fewer people. Neither complaint makes economic sense. The income tax is levied on a business person’s net profits. It has no effect on the question of how best to maximize those profits--how much to produce, what prices to charge, how many people to hire, etc.

To be sure, higher tax rates can reduce the incentive to work and invest for small-business people like any other people. That is an inevitable disadvantage of almost all forms of taxation (though its effects are routinely exaggerated). Unfortunately, taxes are sometimes necessary. But small-business people don’t deserve or require greater protection from taxation’s disincentive effect than people who earn their money in any other way.

If a small-business person decides to plow his or her profits back into the business, those investments can be deducted, either immediately or, at worst, over several years. The money on which a “small business” pays tax is mostly money taken out of the business by the owners.

The small-business lobby has made much of the fact that top tax rates on unincorporated small businesses (above 40%) are now higher than those on major corporations (35%). But shed no tears. Any “small” business big enough for its owners to be in the top tax bracket is big enough to incorporate. If the owners choose not to, it is because the tax advantages of being unincorporated still outweigh the disadvantages.

So go ahead and admire small-business folks. Even be one if you want. (Under the definitions used by the small-business lobby, I’m one myself.) But don’t expect to be canonized for it. And keep in mind the phony claims of the small-business lobbyists during the recent tax debate when evaluating their claims in the coming health-care debate.