February 26, 1997

An Income Tax Cut Is A Poorly Targeted Way For Maryland
To Help Small Businesses and Is Unlikely To Boost State's Economy

Nicholas Johnson

Can a state improve its economy by cutting income taxes? Many advocates of such tax cuts say "yes." But as this analysis shows, tax cuts are often overrated as a tool for economic development.

Proponents of cutting Maryland's top income tax rate justify such a cut by arguing in part that it would promote economic development through its benefits to small businesses. This argument was among the major points made by the Glendening Administration in testimony before the House Ways and Means Committee in February, 1997:

"Nowhere is the argument for a personal income tax rate reduction more clear-cut than in the small business area. Most small businesses structure themselves as Subchapter S corporations, partnerships, Limited Liability Companies (LLCs) or sole proprietorships. Small business owners pay income taxes as sole proprietors or with corporate income flowing through to their individual tax returns. A lower personal income tax rate translates to more capital retained for hiring employees and buying goods and services — often not too far from their base of operations."1

A close examination of the tax treatment of small businesses in Maryland, however, reveals that an income tax cut is a costly and inefficient way to attempt to stimulate job growth in the state.


How S Corporations, Partnerships, Limited Liability Companies and Sole Proprietorships Pay Income Taxes

The small businesses that are the intended beneficiaries of the Governor's proposed personal income tax cut are those known as S corporations, partnerships, Limited Liability Companies (LLCs), and sole proprietorships. (These terms are defined in the box below.) To understand the taxation of these firms' income, it is useful to understand the income taxes that other businesses pay. Maryland tax law — which is based on federal tax law — categorizes most publicly-held businesses, including most major employers, as "C corporations," a status that requires them to pay state corporate income tax on their profits. Corporate income taxes are paid by the corporation itself. After the taxes are paid, the remaining profits may be distributed to shareholders in the form of dividends. To shareholders, these dividends are personal income, subject to the state individual income tax like any other form of income.

Some economists view the taxation of C corporations as "double taxation," since the profits are taxed at both the corporate and individual level. Others argue that it is appropriate for both the corporation and the individual to pay taxes on their income. The corporation and the individual each benefits from the public services financed by the taxes. Moreover, corporate profits and individual income each represents a reasonable source of revenue to support those government services.

A Glossary of Small Business Entities

Subchapter S corporation. "A small business corporation with a statutorily limited number of shareholders [75 under current law], which, under certain conditions, has elected to have its taxable income taxed to its shareholders at regular income tax rates. Its major significance is the fact that Subchapter S status usually avoids the corporate income tax, and corporate losses can be claimed by the shareholders. This election is for ... tax purposes only; in terms of legal characteristics under state law, the 'S' status corporation is no different than any other regular corporation." Black's Law Dictionary, 6th edition, 1991.

Partnership. "A business owned by two or more persons that is not organized as a corporation. ... For income tax purposes, a partnership includes a syndicate, group, pool, or joint venture, as well as ordinary partnerships. ... Partnerships are treated as a conduit and are, therefore, not subject to taxation." Black's Law Dictionary, 6th edition, 1991.

Sole proprietorship. "A form of business in which one person owns all the assets of the business in contrast to a partnership, trust or corporation." Black's Law Dictionary, 6th edition, 1991.

Limited Liability Company. "A limited liability company is a hybrid business entity that combines the limited liability characteristics of a corporation with the pass-through tax treatment of a partnership." U.S. Department of the Treasury, Statistics of Income Bulletin, Fall 1995.

Not all businesses are subject to the corporate income tax. Under federal tax law, the profits of certain types of mostly small, privately held businesses are allocated directly to business owners and taxed only under the personal income tax. Some businesses incorporate as "subchapter S corporations" (so named for the section of the Internal Revenue Code which governs such incorporations). These businesses gain the legal benefits of corporations. Only businesses with fewer than 75 shareholders can choose this status (the limit was 35 until 1996). Other businesses become partnerships; one increasingly popular form of partnership is the Limited Liability Company, which has many of the same legal protections of a corporation. Collectively, S corporations, partnerships, LLCs, and sole proprietorships are known as "pass-through" entities because their profits are "passed through" to individual owners — the partners in a partnership or LLC, the proprietor of a sole proprietorship, or the shareholders of an S corporation. The owners add those profits to their incomes from other sources and pay individual income taxes on the total.

Although this favorable tax treatment has traditionally been viewed as a subsidy for small business, there is no guarantee that a pass-through entity like an S corporation or LLC is, in fact, "small." There are no legal limits on the size of their assets or payroll, and some S corporations, partnerships and LLCs are quite large and profitable. (Goldman Sachs, the New York investment bank with over 8,000 employees and reported 1996 profits of $2.6 billion, is a partnership; so is the 53,000-employee accounting firm Price Waterhouse.) The IRS reports that while the average S corporation is still far smaller than the average C corporation, the gap is narrowing.2


Little of the Total $430 Million Tax Cut Would Accrue to Small Businesses

Profits from the businesses known as "pass-through" entities are a small portion of Marylanders' incomes. Of the $80 billion of Maryland income subject to the individual income tax in 1994, about $3 billion or 3.7 percent was profits from partnerships and S corporations; sole proprietorships accounted for another $2.4 billion or 3.0 percent of income. About three out of every four dollars of Marylanders' incomes — and the bulk of the Maryland income tax base — came from wages, salaries, and tips. Other major sources of income included bank interest, stock dividends, capital gains, and retirement income.

A 10 percent cut in Maryland's personal income tax would cost the state about $430 million a year. Since very little Maryland income is from small business ownership, a very small portion of that $430 million would accrue to small business owners. If the state's objective is to aid small businesses, it can do so in far more efficient and less costly ways than a broad income tax cut.


For Most Small Businesses, the Tax Cut Will Be Too Small to Affect Behavior

Proponents of a tax cut suggest that small businesses would use the proceeds from a tax cut to expand their investment, purchasing more Maryland goods or hiring more Maryland workers. However, the size of the tax cut that would accrue to typical small businesses under the leading tax cut plans are too small to have significant effects on business behavior.

Many struggling small business owners — for instance, owners of start-up enterprises — would not benefit at all from the tax cut. Such businesses often have no taxable profits and hence their owners have no income tax liability associated with the business, although the enterprise may pay substantial sales and property taxes.

Owners of more prosperous businesses also are unlikely to notice much change in their bottom line from a tax cut. Consider the sole owner of a pass-through entity with taxable profits of $100,000 on business revenue of $1 million, with pre-tax costs of $900,000 and state tax liability associated with the business of $5,000.3 (Such a level of profits would make this business among the most profitable of Maryland sole proprietorships; see Table 1.)


Table 1
Maryland Business Owners by Income Class


Sole Proprietors

Partnership, LLC and
S corporation shareholders

Total returns



Distribution of returns by Maryland adjusted gross income:

Less than $50,000



$50,000 to $74,999



$75,000 to $99,999



$100,000 to $199,999



$200,000 and over






* Percentages may not add due to rounding.
Center on Budget and Policy Priorities.
Source: Comptroller of the Treasury, Maryland Statistics of Income 1994.


Cutting the income tax rate from 5 percent to 4.5 percent reduces that business's state income tax by about $500. At the same time, since the business owner can no longer deduct that $500 from his federal income tax return, his or her federal tax will increase by about $155. Total taxes are therefore reduced by $345. As Table 2 shows, such a tax cut would reduce the after-tax cost of business from $935,140 to $934,795, or by 0.037 percent — less than four-hundredths of one percent. A change in business costs that small seems unlikely to change business behavior.

How Would the Structure of an Income Tax Cut Affect Small Businesses?

Proponents of an income tax cut as an economic development tool have argued that this cut must take the form of a rate reduction in order to be effective. Other forms of income tax cuts, however, could provide greater benefits to most small business owners.

Compare two income tax reduction proposals, each of which would cost the state treasury about $430 million when fully phased in. One proposal would cut the top income tax rate from five percent to 4.5 percent. The other would increase the personal exemption. As Figure 1 shows, the rate reduction would provide larger benefits for taxpayers with incomes at and above $100,000. Increasing the personal exemption would provide larger benefits for families with incomes below $100,000, particularly those with incomes of $50,000 and below.

Most small business owners would receive the greatest benefit from the increase in the personal exemption. Over two-thirds of owners of pass-through entities earn under $75,000 and therefore would benefit much more from a personal exemption increase than a rate cut. Only about 9 percent of sole proprietors and about 24 percent of taxpayers with ownership stakes in partnerships and S corporations have incomes over $100,000, the income bracket in which taxpayers are most likely to gain the greatest benefit from a rate reduction.

Even for the most prosperous business owners, those in the top federal income tax bracket, the tax cut would be relatively small. The combined federal, state and local marginal income tax rate — that is, the tax on each added dollar of income — would decline from a maximum of 47.6 percent to 47.1 percent, again a modest difference.


Table 2
Effect of Tax Cut on a Hypothetical Owner of a Pass-through Entity

Business profile: Profits of $100,000 on total revenue of $1,000,000.


Taxes on business profit

Under current law

With an income tax rate cut from 5% to 4.5%

Increase (decrease)

Federal income tax (28% and 31% brackets, after deducting state & local taxes):




State income tax (top bracket):




Local income tax (60% piggyback):




Total income taxes:




Business costs

Under current law

With an income tax rate cut from 5% to 4.5%

Increase (decrease)

Cost of doing business excluding income taxes




Cost of doing business, after taxes





Small Businesses in Maryland Already Receive Favorable Tax Treatment

Maryland's taxation of small businesses is very competitive compared to other states. Total Maryland taxes, measured as a share of personal income, are lower than those of most other states. Maryland's property taxes and corporate income taxes, two taxes which businesses often cite as more important to location decisions than the income tax, are among the nation's lowest. State sales taxes are low too. Studies from sources as diverse as the National Federation of Independent Business and the Federal Reserve Bank of Boston have found that Maryland's taxes on typical businesses are lower than those in many other states.4

Even the state's income tax rate, which proponents of a tax cut have painted as one of the nation's highest, is lower than commonly thought. Although the total burden of income taxes is relatively high compared to other states, the top marginal rate — a combined state-local rate of eight percent — is closer to average. Of the 42 states plus the District of Columbia with income taxes, thirteen have top state-local combined income tax rates higher than eight percent.5

For pass-throughs whose owners do not live in Maryland, the income tax rate is even more favorable. State law requires that non-residents pay state income tax, without the local piggyback tax, on income from Maryland pass-through entities. Most other states have similar requirements. At five percent, Maryland's state income tax rate is among the nation's lowest.

Small businesses receive other benefits in addition to the state's overall low tax level. The option to organize as a pass-through entity (S corporation, partnership, LLC or sole proprietorship) is a substantial benefit to a firm. Unlike C corporations, pass-throughs pay no income taxes themselves. The income of the business entity is taxed one time, on the individual income tax return. By contrast, a C corporation pays taxes on the income it earns, and the owners also pay taxes when they receive that income as dividends.6 (See the Appendix for an example).

The practice of taxing pass-through entities differently from C corporations has several effects. Large, profitable pass-throughs (particularly LLCs and partnerships) may avoid substantial business taxes by diffusing their profits among thousands of owners, many of whom live out-of-state. Firms that are unable to qualify for pass-through status are placed at a competitive disadvantage. And states lose substantial amounts of revenue.

Concern about the practical difficulties of state taxation of pass-throughs at the ownership level persuaded the National Governors Association and the National Conference of State Legislatures, in their report Financing State Government for the 1990s, to conclude that states "should consider [abandoning] federal pass-through treatment and impose either their regular corporate income tax or a special entity-level tax" on S corporations, LLCs and partnerhips.7

Several states have followed that advice at least to some degree. Of states with both an individual income tax and a corporate income tax, at least a dozen states impose substantial business entity taxes on S corporations, LLCs, partnerships, or all three. Such taxes are in addition to the personal income tax owners pay on "pass-through" income. These taxes may be viewed as efforts to level the playing field between taxable C corporations and their competitors who are structured as non-taxable pass-through entities.

A few states do not recognize S corporation status at all. Louisiana and the District of Columbia treat S corporations the same as C corporations for corporate income tax purposes. Michigan taxes all businesses, including sole proprietorships, partnerships, LLCs and S corporations under its "Single Business Tax."

The exemption from corporate income tax does not prevent pass-through businesses from taking advantage of other corporate tax breaks. By basing its tax laws on the federal tax code, Maryland has chosen to adopt a host of Congressionally enacted laws that allow businesses to reduce their tax liability below the statutory rate. While C corporations use these tax breaks to reduce their corporate income tax liabilities, S corporations and other pass-through entities use them to reduce the personal income tax liabilities of their owners.

Business owners may even use those tax breaks to create the illusion that their business is losing money. In some cases the loss can be used to offset income from other sources, in effect sheltering that income from taxation. The federal government estimates that business tax breaks in the federal tax code are worth over $10 billion a year to pass-through entities, and they probably cost the Maryland treasury millions of dollars a year more.9

Maryland thus has chosen, through a series of legislative decisions, to provide more generous tax breaks to small businesses than other states. For example, Maryland could, as other states have, impose the corporate income tax or some other form of business tax on pass-through entities. It does not. In a 1991 report, the Department of Fiscal Services suggested a modest flat tax of up to $400 on S corporations that would raise up to $13 million a year. "Requiring all S-Corps to pay a flat tax would make the tax burden more fairly distributed among all corporations," the report said.10 The tax was not enacted.


A Tax Cut May Do More Harm than Good to the Maryland Economy
Because it Would Force Cuts in Services on Which Small Businesses
and Other Firms Rely

Careful research studies which separate the effects of cutting taxes from other economic factors show that the positive effect on economic growth from cutting taxes — even cutting business taxes alone — is very small. Timothy Bartik of the Upjohn Institute reviewed and analyzed 75 of these studies in a 1991 book.11 On average, the studies found that if total state and local taxes were reduced by 10 percent, the state could expect an increase in local employment over 20 years of around 2.5 percent above the growth that would have occurred without the business tax reduction.

This figure means, for example, that a cut of 10 percent in Maryland's income tax — which would translate to a cut of approximately 1.9 percent in total state and local taxes — might result in increased job growth of 0.5 percent over 20 years, or job growth of approximately 550 jobs per year. This effect is clearly small given the large cost of such a tax cut. In addition, these figures overestimate the actual impact, because they are calculated based on the assumption that the tax cut does not result in a reduction in government spending and thereby lead to a reduction in public services. When the additional service reduction effects are factored in the tax cut would likely result in even smaller job growth or even a decline in the number of jobs in the state.

In fact, additional research has demonstrated the positive impact of spending on government services on job growth. Bartik also reviewed 30 studies of the economic effects of public services on job growth. Of the studies reviewed, 60 percent found that jobs in an area increased when spending on public services increased.

Maryland cannot cut taxes without cutting services. Even without a tax cut, the state Department of Fiscal Services reports that under the proposed budget the gap between revenues and expenditures will be $221 million by 2001. A tax reduction of the scale proposed by the governor, even with a proposed offsetting increase in the cigarette tax, would more than double that gap. By the time the income tax cut is fully implemented in fiscal year 2001, the gap between projected expenditures and projected revenues would increase to $512 million.12 Closing the resulting budget gap with spending cuts would require a major reduction in the services that Maryland provides.

Cuts in public services may be particularly harmful to small businesses. When public services are inadequate, larger businesses may be better able to compensate with private services — for instance, by hiring private security forces to offset police cuts or conducting their own training to compensate for poor public education. Smaller businesses may lack the resources or scale to avoid the effects of spending cuts.



A reduction in the Maryland individual income tax would be a remarkably inefficient way to aid small businesses. Most of the benefits of the tax cut would go to non-business owners. To the extent that business owners do benefit, the value of the tax cut would be quite small and would be further diminished by higher federal income tax liability. Maryland's tax treatment of small business owners is already quite favorable, both compared with other business owners in the state and compared with similar businesses in other states. Even if a tax cut did serve to attract businesses to Maryland, the reductions in public services that such a tax cut would require would have the opposite effect, offsetting the economic gains and possibly worsening the state's economy.


Taxes on Profits of an S Corporation Are Lower than Those of a C Corporation

The table below describes the tax treatment of two Maryland businesses, identical except for their corporate structure: one is an S corporation (or other pass-through entity), the other a C corporation. Each business has $100,000 in pre-tax profits, which are distributed to owners as dividends. This example assumes that shareholders have other sources of income as well, and that all business income is subject to the 28 percent federal tax rate.

As the table shows, pass-through status reduces Maryland tax liability by $2,000 (for nonresident shareholders) to $3,640 (for resident shareholders) — a tax break worth two percent to three percent of total business profits.


Table A-1
The Effect of Pass-Through Status on a Business's Income Tax: An Example


S corporation

C corporation


Pretax corporate profits:





Corporate income tax:

Federal (35%)

State (7%)







After-tax corporate profits distributed to shareholders:



If shareholders live in Maryland:

Individual income tax on shareholders:

Federal (28%)

State & local (8%)







Total corporate and individual income taxes on residents:


MD state & local







If shareholders do not live in Maryland:

Individual income tax on shareholders:

Federal (28%)

State (5%)







Total corporate and individual income taxes on non-residents:


MD state & local








This report was prepared by the State Fiscal Project of the Center on Budget and Policy Priorities, a national nonpartisan research organization and policy institute that conducts research and analysis on a range of government policies and programs, with an emphasis on those affecting low- and moderate-income households.

The State Fiscal Project, which was founded in 1992, prepares analyses and provides technical assistance on state tax and budget issues, with the fundamental goal of enhancing state-level efforts to address social and economic issues confronting low- and moderate-income households. The Center on Budget and Policy Priorities is supported primarily by foundation grants.

End Notes

1. Testimony of Kevin Hughes, Governor's Legislative Office, James Brady, Secretary of Business and Economic Development, and Fred Puddester, Secretary of Budget and Management, submitted to the House Ways and Means Committee (House Bill 502), February 12, 1997.

2. Amy M. Gill, "S Corporation Returns, 1992," in Internal Revenue Service, Statistics of Income Bulletin, Spring 1995, p. 73.

3. This example assumes that the business owner has other sources of income and therefore the full amount of business income is subject to the 5 percent state rate and the 28 percent and 31 percent federal rates. Business owners who derive all or most of their income from their businesses may reduce their tax liabilities through use of exemptions, deductions, and lower bracket rates.

4. The NFIB study was reported in "Comparing State Business Taxes," State Policy Reports, July, 1996. The Federal Reserve study by bank economist Robert Tannenwald was published as "Business Tax Climate: How Should It Be Measured and How Important Is It?" State Tax Notes, May 13, 1996.

5. The states are California, Rhode Island, Oregon, New York, Hawaii, Vermont, the District of Columbia, Ohio, New Mexico, Minnesota, Maine, Kentucky, and Idaho. Kentucky, Ohio and New York have state tax rates below eight percent but combined state-local rates above eight percent. This list excludes several states that allow full deductibility of federal taxes from state taxes, which has the effect of reducing state rates. It also excludes Delaware, where the combined top state and local income taxes exceed eight percent but where some or all income from pass-through entitities is not subject to the local tax.

6. The taxation of C corporations and pass-through entities differ in other ways. One difference is in the treatment of retained earnings. If a C corporation earns a profit but chooses to retain those profits — say, by reinvesting in machinery — no dividends are distributed and shareholders pay no taxes. If an S corporation earns a profit but reinvests those profits, shareholders may be required to pay taxes on the profit even though they have received no money. Often, however, the S corporation can use other tax rules to reduce or eliminate the profit on which its shareholders pay taxes. Another difference is in the treatment of shareholders that live out of state. Shareholders in a Maryland C corporation pay Maryland individual income taxes only if they live in Maryland, while owners of a Maryland S corporation or unincorporated business pay Maryland individual income taxes whether or not they live in Maryland (although nonresidents do not pay the local piggyback tax).

7. Ronald Snell, ed., Financing State Government in the 1990s, 1993, p. 89.

8. Commerce Clearing House, Inc., State Tax Guide 1997; Bruce P. Ely and Joseph K. Beach, "The LLC Scoreboard," State Tax Notes, February 10, 1997.

9. According to the Joint Committee on Taxation, one tax break alone — known in tax parlance as Aaccelerated depreciation," because it allows companies to deduct the cost of capital purchases faster than standard accounting rules would permit — is worth $8 billion in federal tax benefits to pass-through entities. Other tax breaks, mostly pertaining to the ways in which businesses deduct their expenses, are worth another $2 billion.

10. Joint Study Group on Revenues, Final Report, October 29, 1991.

11. Bartik, Timothy; Who Benefits From State and Local Economic Development Policies?; W.E. Upjohn Institute for Employment Research; Kalamazoo, Michigan; 1991.

12. Department of Fiscal Services Budget Forecast, February, 1997.