Some lawmakers have expressed concern over the impact on small business of several proposed increases in the income tax rates for high-income individuals being considered in the current Congress. In his budget request for FY2011, President Obama is proposing to extend permanently most of the individual income tax cuts that were enacted in 2001 and 2003 and are due to expire at the end of 2010. But the request also called for restoring the top two tax brackets (currently 35% and 33%) to their levels prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16 ): 39.6% and 36%; the higher rates would become effective in 2011. Under the proposal, the 39.6% rate would apply that year to all filers with adjusted gross incomes (AGIs) above $373,650, and the 36% rate would affect single filers with AGIs from $200,000 to $373,650 and joint filers with AGIs from $250,00 to $373,650. Upper-income individuals would also face higher marginal tax rates under the versions of health care reform legislation passed by the House ( H.R. 3962 ) and the Senate ( S.Amdt. 2786 to H.R. 3590 ). The House measure would impose a surtax equal to 5.4% of modified adjusted gross income (MAGI) in excess of $500,000 for single filers and in excess of $1 million for joint filers. Though the Senate bill does not include the surtax, it would impose an added payroll tax of 0.5% on the wage income of single filers above $200,000 and on the wage income of joint filers above $250,000; the tax would also apply to self-employed workers with business incomes above those thresholds. Proponents of the proposed rate hikes say they are needed to raise revenue for a variety of crucial budgetary purposes (including reducing projected federal budget deficits). In their view, the hikes would also reverse the decline in the progressivity of the individual income tax ushered in by the sweeping tax cuts enacted during the Bush Administration. Critics, by contrast, argue the rate increases would ultimately shrink the economy's long-term growth potential through their impact on savings, investment, and wages. One of their main concerns is the effect that higher rates would have on small business formation, growth, and investment. Citing recent research findings, critics maintain that firms with fewer than 500 employees historically have accounted for a substantial share of business investment and made important contributions to the commercial development of new technologies. In their view, the proposed higher marginal tax rates would boost the tax burden for many small business owners, reducing their incentives to open new lines of business, expand current operations, or invest in the development of new products and processes. This report seeks to shed some light on the validity of such an argument by exploring what is known about the share of small business owners and of small business income that is subject to the top two marginal income tax rates. The analysis at the heart of this report is built around the distribution of small business income by marginal individual tax rates. While the Internal Revenue Service (IRS) does not release to the general public the data needed to compute such a distribution, the figures can be extracted from the vast store of individual tax data collected by the agency. Using a micro-simulation model, economists at the Tax Policy Center (TPC) jointly managed by the Urban Institute and the Brookings Institution have generated a distribution of small business income and filers with such income by tax bracket for 2007 and 2009. Before discussing the results, however, it is useful to know what is meant by a small business owner and small business income in this context. Providing such an explanation is not as simple or straightforward an exercise as it may appear. This is because a small business can be defined in several ways, and there is no consensus among analysts on the proper or correct definition. Still, a line must be drawn between small business income and all other sources of income in order to determine the share of small business owners and small business income that could be affected by an increase in the marginal tax rates affecting upper-income individuals. In estimating the distribution of small business income by tax bracket, TPC uses the same definition of a small business owner that the Treasury Department has employed in several recent studies. In both cases, such an owner is anyone who reports any income or loss on Schedule C (self-employment income), Schedule E (income from rents, royalties, partnerships, limited liability companies, and S corporations), and Schedule F (farm income). Such a definition seems to have little in common with the popular image of a small business as a start-up firm owned by risk-taking entrepreneurs bent on commercializing some new technology, or a one-of-a-kind family-owned firm serving mostly local customers. There are advantages and disadvantages to using such a definition as a basis for estimating the distribution of small business income by tax bracket. On the one hand, it covers all income earned in a tax year by what are referred to as passthrough entities, many of which could be considered small on the basis of the size of their workforces, revenue, or assets. The definition also makes it possible to separate small business income from all other sources of income using available tax data. On the other hand, the definition has several limitations that call into question its usefulness for policy analysis. First, it excludes income earned by small C corporations and passed on to owners as compensation, dividends, or capital gains. There is no clear economic justification for omitting income from small C corporations when estimating the distribution of small business income by tax bracket. Second, the TPC/Treasury definition allows some firms that could be considered medium-sized or large using different criteria to be counted as small. For example, in 2005, 620,682 S corporations (or 17% of all S corporation tax returns) and 197,404 partnerships (7% of all partnership tax returns) reported receipts of $1 million or more on their federal tax returns; the same firms accounted for 91% of the combined receipts for S corporations and partnerships that year. Third, under the TPC/Treasury definition, it is likely that many upper-income individuals who are what the IRS views as passive investors in partnerships and S corporations are counted as small business owners. In 2004, for example, passive investment income from those entities made up some or all the business income reported by 9% of households, and 58% of all individuals with adjusted gross incomes (AGIs) above $1 million reported receiving some or all of their small business income as passive investment income. Yet another limitation with the TPC definition is that it treats certain kinds of miscellaneous income unrelated to investment or wages as small business income, even though the miscellaneous income has no clear-cut relationship to the ownership and management of a business; noteworthy examples include the fees given to CEOs for sitting on corporate boards, proceeds from sales on eBay, the honoraria received by journalists, and the royalties paid to book authors. It is not known to what extent these limitations might distort a distribution of small business owners or income by tax bracket based on what many would regard as a more plausible definition of a small business owner. The linkages between the individual and business tax data collected by the IRS needed to generate such a distribution simply do not exist. So given the limitations of any distribution of small business owners and income by tax bracket that relies on the TPC/Treasury definition, its results should be viewed as illustrative or suggestive rather than definitive or conclusive. Table 1 shows the key results of the estimated distribution of small business income in 2007 and 2009 generated by TPC's microsimulation model. At least four conclusions relevant to the argument that the growth of small firms would be stunted by a rise in the top two individual tax rates can be drawn from the figures in the table. First, the results indicate that few small business owners face the current top two marginal tax rates of 33% and 35%. Less than 2% of tax filers in those brackets in both 2007 and 2009 reported any small business income. At the same time, a majority of small business owners are subject to marginal tax rates ranging from 0% to 15%: in 2007, 68% of tax filers with small business income were in that position; the share rose to 72% in 2009. Thus, it seems reasonable to conclude that even after allowing for the limitations to the measurement of small business income in the TPC analysis, a tiny share of individual taxpayers who own and are actively involved in the management of firms that many would regard as small on the basis of their employment, revenue, or asset size would be affected by an increase in the top two individual tax rates. Second, small business income is not the dominant form of income in any tax bracket above zero. In 2009, such income totaled anywhere from 6.0% of AGI in the 15% bracket to 39.6% in the 35% bracket. (The high shares shown in the table for the 0% bracket stem from substantial business losses and the use of the absolute value of those losses to compute the ratio of small business income to AGI.) Third, while most filers in the top two brackets report some small business income, a majority derive less than half of their AGIs from small business. In 2009, small business income accounted for over 50% of AGI for 40% of filers in the top bracket and for 33% of filers in the second bracket. Finally, the results suggest that the proposed tax hikes for upper-income individuals would affect a greater share of small business income than small business owners.