Small Firms, Employment, and Federal Policy

Although the most recent recession ended more than 

two years ago, the recovery has been slow and the economy remains in a severe slump. From December 2007 

(when the recession began) to February 2010 (when the 

number of people on business payrolls was at a low 

point), the U.S. economy lost 8.7 million jobs, on net, 

on a seasonally adjusted basis. From February 2010 to 

February 2012, only 3.5 million jobs were created, on 

net, on a seasonally adjusted basis. The Congressional 

Budget Office (CBO) projects that, under current law, 

employment will grow at an average rate of about 

2 million jobs per year over the next few years.1

 At that 

rate, employment will not reach its prerecession peak 

until the middle of the decade. Against that backdrop, 

policymakers, analysts, and the public continue to express 

concern about the prospects for job creation.

It is widely believed that small firms promote job growth. 

In fact, small firms both create and eliminate far more 

jobs than large firms do. On balance, they account for a 

disproportionate share of net job growth—however, that 

greater net growth is driven primarily by the creation of 

new small firms, frequently referred to as start-ups, rather 

than by the expansion of mature small firms. 

The greater net job-creation rates associated with new 

small firms could motivate lawmakers to consider supporting such firms through various policy initiatives. 

However, policies specifically favoring small firms have 

both advantages and disadvantages. For instance, policies 

designed to prevent discrimination or reduce pollution 

would probably have smaller adverse effects on employment if they exempted small firms in those cases 

where compliance was particularly costly for small 

firms. Conversely, some policies CBO has examined that 

would increase employment, such as reducing payroll 

taxes for firms that hire additional workers, would be less 

cost-effective if they were restricted to small firms.

Under current federal laws and regulations, small firms 

already receive more favorable treatment than large firms 

do in many areas. For example, certain provisions of the 

tax code relating to capital gains and the expensing of 

capital investments favor small firms. The Small Business 

Administration (SBA) helps small firms obtain loans. 

And many regulatory policies, such as those prescribed by 

the Family and Medical Leave Act of 1993, include 

exemptions for small firms. Because further efforts to 

favor small firms may shift employment away from large 

firms in an inefficient manner, broadly targeted policies 

may spur total employment more effectively. 

The Role of Small Firms in the 

Labor Market

Small firms employ a substantial share of all workers and 

are among the most dynamic employers in the economy. 

That very dynamism, however, leads small firms to both 

create and eliminate jobs at higher rates than larger firms 

do, in part because small firms come in to and go out 

of existence at much higher rates than their larger 

counterparts—a pattern that persisted through the most 

recent recession. Although small firms do generate jobs 

at higher rates, on net, than larger firms do, that relationship arises primarily because new firms, which typically 

start out small, create a comparatively large share of 

net new jobs. Conversely, older, more established small 

firms create a comparatively small share of net new jobs. 

Thus, even though observers sometimes cite small firms 

as the engine of job growth, the more accurate view is 

that new firms are a particularly important source of job 

growth.

1. See Congressional Budget Office, The Budget and Economic 

Outlook: Fiscal Years 2012 to 2022 (January 2012).

MARCH 2012
2 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY MARCH 2012

CBO

Table 1.

Distribution of Private-Sector Firms and Employment, by Firm Size, 2011

Source: Bureau of Labor Statistics, Business Employment Dynamics database, first quarter of 2011.

Differences in Employment at 

Small and Large Firms 

Analysts measure the size of a business in a variety of 

ways, including using financial measures and market 

shares. In this analysis, CBO measures size primarily on 

the basis of the number of employees working for a firm. 

A firm may consist of only one establishment—such as 

a factory or store that conducts business in a single 

location—or multiple establishments. This analysis 

focuses on firm size because current size-related federal 

policies generally focus on firms rather than establishments. No uniform employee threshold has been adopted 

to define “small,” either in federal legislation or in 

published research, so this analysis considers various 

thresholds.

The vast majority of firms in the United States are small, 

but large firms employ a disproportionately high share 

of all private-sector workers. For instance, in 2011, 

98 percent of all firms had fewer than 100 employees, 

whereas 0.2 percent of firms had 1,000 or more employees, according to the Business Employment Dynamics 

(BED) database compiled by the Bureau of Labor Statistics (see Table 1).2

 However, those small and large firms 

employed about the same share of workers—37 percent 

and 39 percent, respectively. Similarly, more than 95 percent of all firms had fewer than 50 employees, but firms 

with 50 or more employees accounted for more than 

70 percent of overall employment. 

Small and large firms operate in all major industries, 

but the proportion of each industry’s firms that are large 

varies. Manufacturing firms tend to be larger than firms 

in other industries. In 2009—the latest year for which 

industry-level data on firm size are available—13 percent 

of manufacturing firms had 50 or more employees (see 

Table 2). Construction firms, by contrast, are generally 

smaller: Only 4 percent of firms in that industry had 

50 or more employees in 2009.

Small firms tend to pay lower wages and provide less 

generous nonwage benefits (such as health insurance, 

pension plans, and paid time off) than do larger firms.3

For example, CBO estimates that, in 2005, the average 

hourly wages paid to full-time workers in firms with 

Firm Size, by

Employee Count

1 to 4 2,704 56.0 5.5 5.2

5 to 9 944 19.6 6.2 5.9

10 to 19 574 11.9 7.7 7.3

20 to 49 369 7.6 11.1 10.6

50 to 99 122 2.5 8.4 8.0

100 to 249 72 1.5 10.9 10.3

250 to 499 22 0.5 7.5 7.1

500 to 999 11 0.2 7.4 7.0

1,000 or More 10 0.2 40.7 38.6 _____ _____ _____ _____

Total 4,828 100.0 105.4 100.0

Thousands

Number in

All Firms

Percentage of

Millions

Number in

All Employees

Percentage of

Firms Employees

2. The data on employer size that CBO used in this analysis are 

derived from records kept on employers covered by unemployment insurance. Some large, multistate firms have multiple federal 

employer identification numbers and, thus, appear in the BED as 

several different and somewhat smaller firms. As a result, BED 

data may slightly overstate employment at small firms and 

understate employment at large firms. 

3. See Jean Marie Abraham, Thomas DeLeire, and Anne Beeson 

Royalty, “Access to Health Insurance at Small Establishments: 

What Can We Learn from Analyzing Other Fringe Benefits,” 

Inquiry, vol. 46, no. 3 (September 2009), pp. 253–273; Charles 

Brown, James Hamilton, and James Medoff, Employers Large and 

Small (Cambridge, Mass.: Harvard University Press, 1990); and 

Walter Oi and Todd Idson, “Firm Size and Wages,” in Orley C. 

Ashenfelter and David Card, eds., Handbook of Labor Economics, 

vol. 3B (Amsterdam: Elsevier B.V., 1999), pp. 2165–2214.
MARCH 2012 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY 3

CBO

Table 2.

Distribution of Private-Sector Firms, 

by Industry and Firm Size, 2009

Source: Census Bureau, Business Dynamics Statistics database.

100 or more employees were almost 40 percent higher 

than the wages earned by full-time workers in firms with 

fewer than 25 employees.4

 Further, 93 percent of fulltime workers in those larger firms were offered and 

eligible for employer-sponsored health insurance as compared with 58 percent of workers in firms with fewer than 

25 employees. The variations in average wages and 

benefits by firm size largely reflect differences in the 

industry and other characteristics of the firms themselves 

as well as differences in the education, skills, and other 

characteristics of the workers they employ.

Employment at Small and Large Firms During the 

Recent Recession

During the recent recession and the following 18 months 

(that is, between December 2007 and December 2010), 

the number of private-sector jobs declined by 6.6 percent, on net, with declines occurring in all categories 

of firm size. Assessing whether the declines occurred at 

different rates across large and small firms is much less 

straightforward than it might seem. The challenge arises 

because a firm’s size can change over time—this year’s 

large firm may be next year’s small firm, and vice versa. 

The instability of firms’ sizes leads unavoidably to some 

arbitrariness in how changes in employment are assigned 

to different categories of firm size. There are various 

methods for doing so, but no consensus exists as to which 

one is most useful (see Box 1). 

The use of different methods has led some analysts 

to assert that small firms have borne the brunt of the 

economic downturn and others to claim that losses have 

been broadly similar across all categories of firm size.5

According to CBO’s methodology—which relied on 

BED data—the number of employees at firms with fewer 

than 50 workers fell by 7.1 percent from December 2007 

to December 2010, the number at firms with 50 to 499 

workers fell by 8.1 percent, and the number at firms with 

500 or more workers fell by 5.4 percent. Thus, CBO’s 

assessment is that small and medium-sized firms suffered 

disproportionately greater job losses than large firms did 

over the past few years. That difference in employment 

growth by firm size is consistent with the trend observed 

over the preceding decade and a half, during which the 

share of private-sector employment at large employers 

edged up gradually (see Figure 1).

Whether the recent recession has been unusually difficult 

for small firms is unclear because historical data are not 

sufficient to establish a typical pattern for job losses during recessions. In contrast with the recent recession, large 

firms experienced substantially more net job losses than 

small firms did during the 2001 recession. However, during the recession of 1991, there were disproportionately 

greater net job losses in small firms than in large ones.6

4. CBO’s tabulations are based on wave 5 of the 2004 Survey of 

Income and Program Participation (SIPP), which reflects the status of workers in 2005 when data on employers’ offers of health 

insurance were collected. SIPP survey questions allow for three 

categories of firm size: 1 to 24 employees, 25 to 99 employees, 

and 100-plus employees. Thus, those data do not allow CBO 

to calculate statistics separately for firms with fewer or more than 

50 employees.

Industry

Agriculture 2 118

Construction 4 435

Finance, Insurance, and 

Real Estate 4 446

Services 4 2,325

Retail Trade 5 952

Transportation and 

Public Utilities 6 186

Wholesale Trade 7 321

Mining 9 20

Manufacturing 13 250 ______

Total 5 5,054

Share of Firms with 

50 or More 

Employees 

(Percent)

Total Number 

of Firms 

(Thousands)

5. See Jessica Helfand, “All Firm Sizes Hit Hard During the Current 

Recession,” Issues in Labor Statistics, Summary 10-02 (Department 

of Labor, Bureau of Labor Statistics, March 2010), www.bls.gov/

opub/ils/summary_10_02/all_firm_sizes_hit_hard.htm; 

Giuseppe Moscarini and Fabien Postel-Vinay, “The Contribution 

of Large and Small Employers to Job Creation in Times of High 

and Low Unemployment” (draft, June 2011), www.econ.yale.edu/

~gm76/large_employers.pdf; and Aysegul Sahin and others, “Why 

Small Businesses Were Hit Harder by the Recent Recession,” 

Current Issues in Economics and Finance, vol. 17, no. 4 (New York: 

Federal Reserve Bank of New York, July 2011), www.newyorkfed. 

org/research/current_issues/ci17-4.pdf.

6. See Helfand, “All Firm Sizes Hit Hard During the Current 

Recession.”
4 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY MARCH 2012

CBO

One factor contributing to the decline of small business 

employment over the past several years has received particular attention: small firms’ reduced access to credit. (A 

subsequent section of this brief discusses at greater length 

the availability of credit for small firms in recent years.) 

One recent study found that, in 2008 and 2009, workers 

in credit-sensitive industries, such as construction and 

real estate, were more likely to lose their jobs if they were 

employed by small rather than large firms; conversely, 

there was no appreciable difference in the probability of 

job loss across firm sizes in less credit-sensitive industries.7

However, responses to surveys indicate that access to 

credit has not been the main problem facing small 

businesses during the past several years; poor sales, taxes, 

government regulations, and economic uncertainty 

Box 1.

Assessing Changes in Employment at Firms of Different Sizes

One reason that studies have come to different conclusions about the role of small firms in the labor 

market during the recent recession is that they have 

used different methods for measuring changes in 

employment. Those different methods have various 

strengths and weaknesses.

The method that CBO used to calculate the changes 

in employment reported in this analysis is based on 

comparisons of total employment within various 

firm-size categories at different points in time. A 

strength of this method is that it shows the relative 

importance of firms of difference sizes in the labor 

market at a given point in time. As a simple example, 

if total employment at small firms was 1 million at 

the end of 2008 and 1.1 million at the end of 2009, 

the employment growth rate for small firms for 2009 

would be 10 percent using this approach. However, 

because firms start, grow, shrink, and fail on a regular 

basis, the small firms whose employment is measured 

in 2008 may not be the same small firms measured in 

2009. As a result, this approach does not estimate job 

losses or gains at any fixed set of small firms. In particular, when larger firms shrink and become small 

firms, the workers remaining in those firms are then 

reclassified as small-firm workers, offsetting some of 

the job losses experienced by firms that were small 

initially. 

An alternative approach is to measure employment 

changes within specific firms whose size class is based 

on their employee count at the beginning of the 

period. A drawback of that approach, however, is 

that the number of people employed at a given 

firm fluctuates from year to year even in times of 

economic stability. If a firm has an unusually high 

number of employees one year, it will often see a drop 

in employment in the next, and vice versa. That 

phenomenon—sometimes known as regression to the 

mean—can lead to the incorrect impression that large 

firms are shrinking and small firms are growing even 

if the sizes of all firms are simply oscillating around 

stable long-run levels.

Yet another approach is the “dynamic sizing” method 

used by the Bureau of Labor Statistics in its Business 

Employment Dynamics program. Using that methodology, when a firm changes from one size category 

to another, losses and gains are allocated across categories. If, for example, a firm with 500 workers 

suddenly shut down, employment in the category of 

“500 or more workers” would show the loss of only a 

single job; the rest of the employment loss (499 jobs) 

would be allocated among smaller firm-size categories 

even though the firm in question never operated at 

those employment levels. Consequently, that 

approach tends to overstate job losses at small firms 

when the economy is contracting and firms are 

closing.

7. See Burcu Duygan-Bump, Alexey Levkov, and Judit MontoriolGarriga, Financing Constraints and Unemployment: Evidence 

from the Great Recession, Working Paper No. QAU10-6 

(Boston: Federal Reserve Bank of Boston, December 14, 2011), 

www.bos.frb.org/bankinfo/qau/wp. That study defines a small 

firm as having fewer than 500 workers.
MARCH 2012 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY 5

CBO

Figure 1.

Share of Private-Sector Employment, 

by Firm Size, 1993 to 2010

(Percent)

Source: Bureau of Labor Statistics, Business Employment 

Dynamics database.

have been mentioned more frequently as problems.8 In 

addition, a recent survey of loan officers indicates that 

banks have not tightened lending standards, on net, 

during the past two years for small firms.9

 Among firms 

with less than $50 million in annual sales, the share 

reporting that they received none of the credit they 

wanted in the preceding year declined from 23 percent 

in late 2009 to 16 percent in October 2010.10

Job Creation and Firm Size

Across all size categories, firms are continually growing 

and shrinking. Thus, even in a period of stable overall 

employment, substantial “churning of labor”—the loss 

of jobs at some firms, the gain of jobs at others—occurs 

among shrinking and growing firms. Churning rates are 

much higher for small firms than for large firms. Annual 

employment gains and losses each amount to more than 

10 percent of employment among firms with fewer than 

20 employees, whereas gains and losses are roughly 2 percent to 3 percent of employment among firms with more 

than 1,000 employees (see Figure 2). Employment shares 

at smaller firms stay roughly constant over time because 

their higher job-creation rates are offset by nearly equivalent rates of job destruction and because fast-growing 

small firms “graduate” into larger firm-size categories.

Job creation slowed and job destruction accelerated in 

firms of all sizes after the recession started in December 

2007. Job-creation rates began to rise and job-destruction 

rates began to fall in 2009, halting further decreases in 

employment. For the most part, job-destruction rates 

returned to their prerecession levels by 2010, but jobcreation rates did not.

Although studies often show that, on net, small firms 

create more jobs than large firms do, the strength of the 

relationship varies with the technical approach and data 

used.11 Recent research, however, has found that it is 

young small firms, especially start-ups, that grow faster—

and consequently create jobs at a higher rate—than either 

large firms or established small firms do. One study 

found that the smallest firms, those with between one 

and four employees, grew 4.7 percent faster than the 

largest firms, those with more than 10,000 employees.

8. See William C. Dunkelberg and Holly Wade, Small Business 

Economic Trends (Washington, D.C.: NFIB Research Foundation, 

February 2012), www.nfib.com/research-foundation/

small-business-economic-trends-sbet-archive; and John K. Paglia, 

Private Capital Markets Project, Survey Report No. 5 (Los Angeles, 

Calif.: Pepperdine University, Graziadio School of Business 

and Management, Summer 2011), Figure 7, www.bschool.

pepperdine.edu/appliedresearch/research/pcmsurvey/content/

PCMPsummer2011.pdf.

9. See Board of Governors of the Federal Reserve System, The 

January 2012 Senior Loan Officer Opinion Survey on Bank Lending 

Practices (January 2012).

1993 1995 1997 1999 2001 2003 2005 2007 2009

0

5

10

15

20

25

30

35

40

1 to 19 Employees

20 to 49 Employees

50 to 99 Employees

100 to 999 Employees

1,000 or More Employees

10. See William J. Dennis, Jr., Small Business Credit in a Deep 

Recession (Washington, D.C.: NFIB Research Foundation, 

February 2010), p. 31, www.nfib.com/Portals/0/PDF/AllUsers/

research/studies/Small-Business-Credit-In-a-Deep-RecessionFebruary-2010-NFIB.pdf; and William J. Dennis, Jr., Financing 

Small Businesses: Small Business and Credit Access (Washington, 

D.C.: NFIB Research Foundation, January 2011), p. 42, 

www.nfib.com/Portals/0/PDF/AllUsers/research/studies/SmallBusiness-Credit-Access-NFIB.pdf. 

11. For studies that show that small firms create a disproportionate 

share of new jobs, see David Neumark, Brandon Wall, and Junfu 

Zhang, Do Small Businesses Create More Jobs? New Evidence from 

the National Establishment Time Series, Working Paper No. 13818 

(Cambridge, Mass.: National Bureau of Economic Research, 

2008), www.nber.org/papers/w13818; Bruce A. Kirchhoff and 

Bruce D. Phillips, “The Effect of Firm Formation and Growth on 

Job Creation in the United States,” Journal of Business Venturing, 

vol. 3, no. 4 (1988), pp. 261–272; and David L. Birch, Job 

Creation in America: How Our Smallest Companies Put the Most 

People to Work (New York: Free Press, 1987). For a study that finds 

no relationship, see Steven J. Davis, John C. Haltiwanger, and 

Scott Schuh, Job Creation and Destruction (Cambridge, Mass.: 

MIT Press, 1996).
6 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY MARCH 2012

CBO

Figure 2.

Total Job Creation and Destruction as a Share of Private-Sector Employment, by 

Firm Size, 1993 to 2010

(Percent)

Source: Bureau of Labor Statistics, Business Employment Dynamics database.

However, when the comparison is made between firms of 

the same age, small firms grow more slowly than large 

firms do.12

Almost all firms start small. Many fail and, of those that 

do survive, most have no desire to expand beyond “small 

firm” status.13 Only a few grow substantially and become 

large firms. Thus, the faster average growth of young 

small firms is driven by the ambitions and successes of a 

fairly narrow set of start-up employers.

Advantages and Disadvantages That 

Varying Policies by Firm Size Could 

Have for Overall Job Growth

For the purpose of promoting job growth, policies 

favoring small firms can have both advantages and 

disadvantages. 

One advantage relates to the cost of complying with 

federal regulations, which may be especially burdensome 

for small firms. For example, compliance with federal 

regulations—such as those aiming to prevent discrimination or reduce pollution—often requires that firms 

develop internal systems or procedures that have a fixed 

cost per firm in addition to costs that vary with the size 

of the firm. In that case, achieving the goal of the regulation at small firms will be relatively more costly than 

achieving it at large firms. Therefore, policymakers may 

reasonably decide to apply certain regulations in modified 

form at small firms or to exempt small firms from some 

regulations altogether.14 Such an approach could promote 

employment growth.

In contrast, a disadvantage of policies favoring small firms 

is that such policies may inadvertently discourage certain 

firms from increasing in size and losing that preferential 

treatment. Moreover, exempting small firms from certain 

regulations, or modifying regulations applied to small 

firms, may allow more of certain problems—such as 

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

0

2

4

6

8

10

12

14

1 to 19 Employees

20 to 49 Employees

50 to 99 Employees

100 to 999 Employees

1,000 or More Employees

Gains Losses

12. See John C. Haltiwanger, Ron S. Jarmin, and Javier Miranda, 

Who Creates Jobs? Small vs. Large vs. Young, Working Paper No. 

16300 (Cambridge, Mass.: National Bureau of Economic 

Research, August 2010), www.nber.org/papers/w16300.

13. See Erik Hurst and Benjamin Wild Pugsley, “What Do Small 

Businesses Do?” (draft, University of Chicago, September 2011), 

http://faculty.chicagobooth.edu/erik.hurst/research/.

14. See Dhammika Dharmapala, Joel Slemrod, and John Douglas 

Wilson, “Tax Policy and the Missing Middle: Optimal Tax Remittance with Firm-Level Administrative Costs,” Journal of Public 

Economics, vol. 95 nos. 9-10, (October 2011), pp. 1036–1047.
MARCH 2012 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY 7

CBO

discrimination or pollution—to persist than would be 

the case if regulations were applied uniformly across firms 

of different sizes. 

More generally, the effectiveness of achieving job growth 

by targeting policies at small firms depends on how the 

details of the policies relate to the various ways that small 

and large firms differ. In some cases, targeting policies at 

small firms might be more effective than using broader 

policies, but in other cases, the opposite is true. For 

example, CBO has analyzed options for spurring employment by temporarily reducing employers’ payroll taxes 

when their firms hire additional workers. Because jobs 

provided by small firms are less “durable” (that is, such 

jobs are more likely to be later eliminated), the economic 

benefits of each subsidized job are lower if the payroll tax 

cut is restricted to small firms. In addition, because of the 

higher volatility of employment at small firms, a larger 

share of a tax reduction targeted at small firms would 

pay for employment growth that would have occurred 

without the policy, thereby reducing the policy’s costeffectiveness relative to a comparable tax reduction 

offered to all firms.15

Note also that projecting policy effectiveness based on 

historical rates of job growth at small firms or other measures of past performance may not be appropriate. For 

example, a study of high-growth firms conducted in 2007 

would have concluded that the construction of residential 

housing—which involves a disproportionate number of 

small firms—was a large source of net job growth during 

the previous decade. However, a policy implemented in 

2007 to support employment in that industry probably 

would not have had much effect on employment over the 

next several years because the conditions that previously 

generated growth in that industry were not sustainable. 

The Federal Policy Environment 

Faced by Small Firms

The ability of all firms to expand or become more 

efficient—that is, to produce goods and services in a 

more cost-effective way—is influenced by federal policies 

that determine the taxes those firms pay, the availability 

of credit, the regulations with which they must comply, 

and other factors. In many cases, the current federal 

policy environment is more favorable to small businesses 

than to large ones; in other cases, the reverse is true. 

Tax Policies

Tax policies can significantly affect decisions about 

whether to start a new business or to expand an existing 

firm. Some provisions of the tax code explicitly distinguish between large and small firms on the basis of 

employee count. For example, under the Affordable Care 

Act enacted in 2010, tax credits are available to businesses 

with 25 or fewer full-time-equivalent employees to help 

cover the costs of providing those employees with health 

insurance; and, beginning in 2014, penalties will be 

imposed on certain businesses with 50 or more employees 

that do not offer health insurance.16

Because the Internal Revenue Service cannot easily verify 

the number of a firm’s full-time employees, the tax code 

typically uses other criteria—such as the amount of a 

firm’s investments or its assets or income—to differentiate between large and small businesses. For example, 

firms with relatively small amounts of qualifying capital 

investment (primarily, tangible resources such as equipment) benefit from an “expensing” provision that allows 

them to fully deduct such costs in the year those assets are 

placed into service rather than over time as their value 

depreciates. The maximum amount a firm can expense 

in 2012 is $139,000; that amount phases out dollar for 

dollar for purchase amounts above $560,000, so that 

provision does not provide benefits to firms purchasing 

$699,000 or more of equipment. The provision implicitly favors smaller firms because they tend to make 

smaller capital investments than larger firms. Under current law, the maximum expensing amounts and phaseout 

thresholds will fall to $25,000 and $200,000 in 2013 and 

beyond, so the provisions will be increasingly targeted to 

smaller firms in the future. 

Another tax-code provision helps small and mostly young 

firms attract capital by reducing the capital gains tax that 

investors pay upon sale of the firms’ stock. The tax is 

reduced by allowing investors to exclude from taxation 

half or more of the gains on such investments (although 

the remaining gains are taxed at regular income tax rates, 

15. For additional discussion, see Congressional Budget Office, letter 

to the Honorable Robert P. Casey, Jr., providing information on 

reducing payroll taxes to encourage employment (February 3, 

2010).

16. The maximum credit for small firms is available only to firms with 

10 or fewer full-time-equivalent employees with average taxable 

wages of $25,000 or less. The credit phases out as employment 

and average wages rise.
8 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY MARCH 2012

CBO

up to a maximum of 28 percent). To qualify for such 

favorable treatment, a firm’s assets cannot exceed $50 million at the time stock is issued and the firm cannot be in 

certain lines of business, such as law, finance, or the restaurant industry; in addition, the investor must purchase 

the stock at the time it is issued and hold it for more than 

five years. Among those benefiting from the provision are 

venture capital funds and start-up firms making their 

initial public offerings of stock. 

Other provisions of the tax code do not explicitly treat 

large and small firms differently but, by their nature, may 

have that effect. For example, the tax code implicitly 

favors small businesses in that statutory tax rates increase 

with net business income. Businesses with lower gross 

receipts, therefore, are typically taxed at lower rates. 

In addition, large and small businesses tend to choose 

different organizational structures—a choice that has 

tax consequences that may or not be advantageous to 

small businesses. Large businesses are more likely to 

incorporate and become subject to the corporate income 

tax. Those corporations may choose to retain their 

after-tax profits for future investment, which tends to 

increase the value of corporate stock, or they may distribute them as dividends to shareholders. Shareholders pay 

individual income tax on corporate dividends at rates up 

to 15 percent, and they pay tax on capital gains at rates 

up to 15 percent when they sell their shares of stock.17

Either way, profits of such corporations are taxed once at 

the corporate level and again at the shareholder level. 

Small businesses are more likely to be organized as “passthrough entities” such as sole proprietorships and partnerships; those organizational forms are not subject to the 

corporate income tax. Their profits (even those retained 

by the firm) are deemed to pass through to their owners, 

where they are taxed at the individual level. For investments not financed through borrowing, the pass-through 

tax treatment results in a lower effective tax rate—and 

higher after-tax profits—than does the tax treatment of 

firms subject to the corporate income tax, effectively giving an advantage to small businesses. For investments 

financed through borrowing, however, the opposite is 

true, putting small businesses at a disadvantage. 

Some observers maintain that the estate tax poses a hardship for small businesses and family farms. They base 

their concerns on the fear that beneficiaries of estates may 

have to wholly or partially liquidate the business or farm 

if building up such an enterprise has resulted in a taxable 

estate without enough liquid assets to pay estate taxes.18

However, the tax code contains special provisions to 

reduce the burden of the estate tax on small businesses 

and family farms. Very few such enterprises have sufficient assets to trigger estate taxes upon the owner’s death; 

and among those that do, the vast majority of estates, 

including those of farmers and small-business owners, 

have enough liquid assets to pay the estate taxes they 

owe.19 Some of those observers also charge that, because 

the estate tax lowers the rewards from investment, a 

business owner or family farmer wishing to leave the 

enterprise (whether large or small) to his or her heirs 

may be less inclined to invest in it or to hire workers—or 

may even be dissuaded from starting the business or farm 

in the first place. Those effects, however, may be mitigated by other factors. First, some people with taxable 

estates leave larger estates than they originally intended 

because they did not live long enough to spend more of 

their savings; the estate tax is unlikely to affect the behavior of those people. Second, some heirs may be less likely 

to work or to start their own businesses if they expect to 

receive a large inheritance. 

Credit Policies

Many businesses depend on financing to grow and to hire 

workers. Typical sources of financing for small businesses 

include personal savings, bank loans (such as business 

loans, equity loans secured by primary residences and 

investment property, and credit lines), funds from 

friends and family, credit cards, vendor financing, and 

various equity arrangements.20 External financing for 

small firms—that is, from sources other than personal 

savings—most commonly takes the form of bank loans. 

In contrast, large firms have greater access to capital markets, where they can raise equity through the sale of stock 

17. In 2013, the tax rate on dividends is scheduled to revert to the rate 

on ordinary income—as high as 39.6 percent for some taxpayers. 

The tax rate on capital gains is scheduled to increase to a maximum of 20 percent.

18. For example, see Patrick F. Fagan, How the Death Tax Kills Small 

Businesses, Communities—and Civil Society, Backgrounder No. 

2438 (Washington, D.C.: Heritage Foundation, 2010), www.

heritage.org/Research/Reports/2010/07/How-the-Death-TaxKills-Small-Businesses-Communities-and-Civil-Society.

19. See Congressional Budget Office, Federal Estate and Gift Taxes, 

Issue Brief (December 2009); and Effects of the Federal Estate Tax 

on Farms and Small Businesses (July 2005). 

20. See Paglia, Private Capital Markets Project, Figure 7.
MARCH 2012 SMALL FIRMS, EMPLOYMENT, AND FEDERAL POLICY 9

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(through public offerings and private-equity placements) 

and borrow funds through the public issuance of debt 

(such as long-term bonds and short-term commercial 

paper) and through lines of credit from groups of banks. 

As a supplement to private financing, the federal government has historically provided loan guarantees that 

enable small firms to borrow at more attractive terms 

(for example, lower interest rates and fees) than they 

might otherwise obtain. In particular, the Small Business 

Administration guarantees loans to some borrowers that 

are otherwise unable to meet commercial lenders’ underwriting criteria. Through its 7(a) Loan Program, SBA 

guarantees loans to small businesses for the purchase 

of land, buildings, equipment, machinery, and supplies, 

as well as to pay short-term operating expenses, such as 

salaries. Additionally, SBA’s Certified Development 

Company/504 loan program guarantees long-term 

financing to small firms to help them acquire significant 

fixed assets for expansion or modernization. 

The recent financial crisis disproportionately affected 

small businesses’ access to capital. During the recession, 

asset values and household wealth fell, making it more 

difficult to fund small-business activities using personal 

wealth or to obtain credit using personal assets as collateral. As of June 2010, the outstanding value of loans 

to small firms had declined by 6.5 percent, to about 

$650 billion, from a peak of $700 billion in June 2008.21

That decline probably reflects declines in both the 

demand for and supply of loans—and the relative importance of those factors is difficult to quantify. In general, 

the demand for loans decreases during recessionary 

periods when the pace of economic activity is slower and 

the supply also decreases as banks tighten their credit 

standards.

To increase the supply of credit to small firms, the American Recovery and Reinvestment Act of 2009 (ARRA) 

raised the 7(a) loan limits and guaranteed lending to 

refinance commercial real estate loans. The number of 

lenders participating in the 7(a) program increased by 

27 percent from 2009 to 2010, the total number of loans 

approved under the 7(a) and 504 programs increased by 

14 percent, and the total dollar amount of loans approved 

under the 7(a) and 504 programs increased by 29 percent. The Small Business Jobs Act of 2010 further 

increased loan limits available under the 7(a) program 

and increased loan limits available through the 504 program as well; at the same time, the act also waived the 

loan fees usually assessed in those two programs. Despite 

those program changes, the lending guaranteed by SBA 

through its 7(a) and 504 programs constituted less than 

3 percent of total small-business lending in 2010. 

ARRA also established the Small Business Lending Fund, 

which allocated up to $30 billion to community banks 

and community development loan funds with less than 

$10 billion in assets to encourage them to increase their 

lending to small businesses. As of September 2011, however, demand for those funds remained low, with only 

$4 billion distributed to qualifying lending institutions.22

Regulatory Policies

Smaller firms are exempt from a variety of laws and regulations that apply to larger firms. For example, the 1972 

amendments to the Civil Rights Act of 1964 explicitly 

exclude firms with fewer than 15 employees.23 Similarly, 

federal contractors with 50 or more employees must 

develop affirmative action programs that are subject to 

compliance review by the Office of Federal Contract 

Compliance Programs.24 Those reports count employees 

by sex and race or ethnic category for each of 10 occupational categories and subcategories. Companies also use 

the information in those reports to prepare affirmative 

action plans indicating how they plan to address any statistical shortfalls that may exist in their employment of 

people in certain demographic groups. Apart from those 

reports, large contractors may have their compensation 

practices reviewed and compared against formal standards for interpreting nondiscrimination requirements, 

and a contractor may be declared ineligible for federal 

contracts if its compensation practices are found to be 

21. Based on data collected by Highline Financial from call reports 

submitted to the Federal Financial Institutions Examination 

Council from June 2008 through June 2010. Loans to small firms 

are defined as loans of $1 million or less. For more details, see Federal Deposit Insurance Corporation, “Loans to Small Businesses 

and Small Farms” (2010), www.fdic.gov/regulations/resources/

call/crinst/2010-03/310RC-C2_03312010.pdf. 

22. Department of the Treasury, “Small Business Lending Fund 

Provides More Than $4 Billion to 332 Community Banks Across 

the Nation” (press release, Washington, D.C., September 28, 

2011), www.treasury.gov/press-center/press-releases/Pages/

tg1315.aspx.

23. Equal Employment Opportunity Act of 1972, 42 U.S.C. 

§2000e(b).

24. 41 C.F.R. §60-2 (2009).
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systemically discriminatory. Small contractors are not 

subject to those reporting requirements or those rules 

regarding compensation practices.25 Another example of 

regulations that do not apply to small employers is the 

Family and Medical Leave Act of 1993, which exempts 

firms with fewer than 50 employees.26

In addition, some environmental rules apply more stringently to large firms. For example, the Environmental 

Protection Agency maintains the Toxics Release Inventory database, which records the nature and location 

of toxic materials released into the environment. The 

reports that generate that database are prepared by 

businesses, and larger firms face greater reporting 

requirements.27

Lastly, many federal contracting programs contain setasides for small businesses that guarantee they will receive 

a minimum share of federal contract dollars. For example, the Small Business Innovation Research program 

awards contracts worth billions of dollars in bidding 

processes open only to small firms.28

Other Policies

Federal investments in infrastructure, tax credits for 

research and development, and funding for basic 

scientific research enhance the economic environment in 

which all firms operate. Those policies do not target firms 

of any specific size, but they may generate market opportunities that contribute to the formation of new small 

firms and the creation of new jobs. For example, small 

Internet companies would not exist had the federal 

government not funded the original research and development that led to the creation and growth of the 

Internet. In addition, even if larger firms are better able to 

take advantage of certain federal policies that support 

research and development or that expand certain business 

markets (for example, through the sale of portions of the 

electromagnetic spectrum), their responses may ultimately benefit smaller firms—as was the case when larger 

companies marketed so-called smart phones, and smaller 

companies developed applications for those phones.

25. See William J. Carrington, Kristin McCue, and Brooks Pierce, 

“Using Establishment Size to Measure the Impact of Title VII and 

Affirmative Action,” Journal of Human Resources, vol. 35, no. 3 

(Summer 2000), pp. 503–523.

26. Family and Medical Leave Act of 1993, 29 USC §2601 et seq.

27. See Environmental Protection Agency, Toxic Chemical Release 

Inventory Reporting Forms and Instructions (October 2009), p. 1, 

www.epa.gov/tri/report/rfi/ry2009rfi121709.pdf.

28. See Scott J. Wallsten, “The Effects of Government–Industry 

R&D Programs on Private R&D: The Case of the Small Business 

Innovation Research program,” RAND Journal of Economics, 

vol. 31, no. 1 (Spring 2000), pp. 82–100.

This brief was prepared by Gregory Acs, formerly 

of CBO, and William Carrington of CBO’s Health 

and Human Resources Division under the general 

supervision of Linda Bilheimer. John Haltiwanger 

of the University of Maryland and Erik Hurst of the 

University of Chicago provided thoughtful comments. 

The assistance of external reviewers implies no responsibility for the final product, which rests solely with 

CBO. This brief and other CBO publications are 

available at the agency’s Web site (www.cbo.gov).

Douglas W. Elmendorf

Director