By JACK HOUGH
Politicians often call> small businesses the "engine of job growth." For example, President Barack Obama used the phrase in a February 2010 speech to New Hampshire voters while detailing new, targeted tax breaks. It's a pleasing notion -- that mom-and-pop entrepreneurs, not corporate fat cats, do more hiring and so deserve more help. It's not especially factual, however.
"Our main finding is that once we control for firm age there is no systematic relationship between firm size and growth," reads a National Bureau of Economics Research working paper that has been circulating since August. In other words, young companies do the hiring. Small, established ones do not.
Small businesses are clearly the engine of something else, however, which I doubt politicians will work into their speeches: Tax underpayment. The numbers suggest no one shirks their duty as taxpayers more than sole proprietors -- not corporations, and certainly not wage-earners.
America's tax gap -- the difference between what the Internal Revenue System reckons it should collect in a given year and what it does collect -- is thought to be about $350 billion. The IRS last released detailed estimates in 2005 using 2001 tax data. The tax gap then was $345 billion. How big is that? The nation's total tax bill that year was $2.1 trillion, meaning 16% went unpaid; enforcement efforts later brought in $55 billion, leaving a gap of $290 billion, or 14% of the bill.
Taxpayers shortchange the IRS in one of three broad ways. Some don't file. Others file honestly but don't pay. Most file and lie. "Underreporting" accounted for $285 billion of the gross tax gap. A recent New York Times story about the shockingly low taxes paid by General Electric (GE)
The IRS based its last estimates on intensive reviews of 45,000 randomly selected returns. It's working now on a fresh estimate using 2006 data. (After that, it will report yearly updates using a smaller set of returns and a rolling three-year trend.) Preliminary findings suggest little has changed. One-quarter of sole proprietors reported losses in 2006, a figure the IRS dryly calls a "noticeable proportion." That's not due to the recession. In 2006, house prices were peaking, the stock market was soaring and just about anyone who could put on pants in the morning was earning a wage or turning a profit. Among sole proprietors who reported losses, 70% were "non-compliant," estimates the IRS.
"It's basically businesses that deal in cash," says Eric Toder, co-director of the Urban-Brookings Tax Policy Center. "If you're a wage-earner, you have automatic withholding and an employer who reports your income to the IRS. If you're a cash business, the IRS has no automated way of checking, and it has limited resources for audits."
Among taxpayers like wage-earners, who are subject to withholding and reporting, the compliance rate is 98%.
Options are limited for prodding small businesses to pay more of their share. Third-party verification of credit card transactions has helped, according to James White, director of tax issues for the Government Accountability Office, but other steps, like limiting losses for tax purposes, would risk negatively affecting business owners who report honestly. Investigators can catch businesses that underreport cash income by, for example, looking at bank accounts, expenses and the number of employees, or by looking for cases where the percentage of credit card sales is suspiciously higher than industry averages. Such investigations are costly, however.
"There's only so far you can go," says Toder. "You can't require people to send a note to the IRS every time they go into a store and spend $5.75. You're going to have a certain amount of leakage from the legal cash economy."