The Best Argument for the Extension of the Bush Tax Cuts for Top Earners

by Veronique de Rugy

AEI’s Alan Viard has written a great piece on why letting the tax cuts on high-income earners expire would seriously hinder economic growth. He also cautions his fellow tax-cut-extension advocates against using misplaced arguments — “about small-business aid and Keynesian demand stiumulus” — that could ultimately get in a way of fundamental tax reform:

[If the tax cuts expire], much of the blame will rest with supporters of the Bush tax cuts. Over the last nine years, the high-income rate reductions have been the neglected stepchild of the tax cuts. The Bush administration downplayed these reductions when the 2001 tax cut was adopted, and supporters have generally failed to make the growth case for them. Most defenses of the high-income rate reductions continue to rely on misplaced arguments about small-business aid and Keynesian demand stimulus. These arguments solidified political support for the initial passage of the tax cuts, but impeded the establishment of lasting pro-growth tax policy. Laying a firm foundation for sound tax policy will require bringing the neglected stepchild in from the cold and making the economic-growth case for the high-income rate reductions.

I am glad that Viard is making the argument that focusing on small businesses is not a good idea.

To begin, the argument is often founded on the mistaken premise that small firms are inherently better than large firms, which suggests that the government should interfere with market forces to promote the former over the latter.

I totally agree. If policymakers’ main goal is to create new jobs, it doesn’t make sense to favor small firms over large or vice versa. New jobs come from small and big businesses. Small businesses — firms with fewer than 500 employees, according to the official definition — make up 99.7 percent of all employer firms and account for about half of the country’s total employment. Companies that employ more than 500 workers represent only .3 percent of all employer firms in the U.S., and yet they account for about half of the country’s total employment. In the 1990s, large multinational corporations created jobs more rapidly than other companies, and they have been vital to employment in the subsequent decade as well.

The misplaced worship of small businesses has been a puzzle to me for many years. Here is an important point to keep in mind: Using data from the Census Bureau Business Dynamics Statistics and Longitudinal Business Database, economists Haltiwanger, Jarvin, and Miranda explored the many issues regarding the role of firm size and growth. They found that once we control for firm age, there is no systematic relationship between firm size and growth. Their finding is that “young” rather than “small” is the factor in U.S. job creation. The confusion then comes from the fact that young firms are small.

This has serious policy implications: The government’s current policies promote 50 percent of the workforce at the expense of the other 50 percent. That’s the problem with preferential government policies in business: They choose the interests of one group over another, which creates a host of problems.

Special treatment creates special-interest groups, and special-interests groups tend to undermine the application of economic-efficiency criteria. Preferential government policies for small businesses have, for example, inspired those small businesses to join together to protect their benefits and lobby for more. Thus joined together, small businesses have lobbied for policies that benefit all small businesses equally.

Special but equal treatment may sound great in theory, but in practice, it’s highly inefficient. This equal treatment diverts resources to businesses that do not deserve it. Moreover, special treatments rarely go away, even when the original conditions change and even if the policy is a failure. Government officials are reluctant to acknowledge policy failure, and the targeted group has a strong incentive to want the policies to be made permanent.

In addition, special treatment for small businesses often creates perverse side effects. A tax code that favors small firms over large ones, for instance, makes it more profitable to stay small rather than grow. This perverse incentive leads to a misallocation of resources away from their most productive uses and interferes with the natural growth and evolution of firms. Preferential regulatory treatment has the same effect.

In other words, small businesses are great, but no greater than firms of other sizes. We have to stop designing our policy recommendations around these fake size criteria, because the consequence is inevitably bad policies.

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