At the end of 2010, the lower income tax rates provided in the 2001 tax cuts were to expire. President Obama had proposed to extend most of the income tax cuts, but to continue some higher tax rates for couples with income over $250,000 and singles with income over $200,000. The most important element of this proposal, as measured by revenue effect, is allowing the top two rates of 33% and 35% to expire. These rates would have risen to 36% and 36.9%. This proposal would have raised $369 billion over FY2011-FY2020, about half of the total from all proposals for not extending tax cuts for these high-income taxpayers. At the end of December, P.L. 111-312 extended all tax cuts for two years. Thus the issue of extending the tax cuts will continue as an issue in the 112 th Congress. Although a variety of issues surround this option, this report focuses on a particular issue, the effect on small business owners, and in turn, the potential effects on employment. Some critics of allowing the tax rates to rise express concerns about possible negative effects on small business owners' hiring and the dampening effect on job creation. This argument is buttressed by a popular conception that small businesses are responsible for the majority, perhaps the vast majority, of new jobs. In some cases, this issue appears to relate to the short term, which has been addressed, for now, with the temporary extension. If the economy continues with high unemployment, as some project, the short-term issue may re-emerge. In some cases the issue appears to relate to longer-term issues and will be relevant to the question of permanent policy. The first section of this report addresses the effects of the changes in top rates, and how well these revisions target small businesses. Two aspects of targeting are considered: the fraction of small businesses affected by the rate changes and the fraction of revenue gain accruing to taxpayers other than these small businesses. The results suggest that only a small fraction of small businesses will be affected, around 2% to 3%. They also suggest that 80% of the reduced taxes are likely to accrue to non-businesses income and about 90% to non-business income or businesses without employees. The second section of the report reviews the claim that small businesses are the primary creators of jobs. This perception is based on research published originally in the 1980s. More recent research has revealed some methodological deficiencies in these original studies and suggests that small businesses contribute only slightly more jobs than other firms relative to their employment share. In addition, this differential is not due to hiring by existing small firms, but rather to startups, which tend to be small. This section also briefly summarizes issues raised by some researchers about the quality of jobs in the small-business sector. The third section reviews the evidence on the effect of taxes on entrepreneurship and self-employment. The results of these studies are mixed, but overall they do not suggest that lower taxes are likely to increase self-employment. The following section discusses perhaps the most important issue to consider, job creation as a policy justification for targeted provisions. The basic economics of market equilibrium indicate that, in the long run, there is no need for the government to intervene in the creation of jobs. In the short run, intervention is appropriate during a recession, but tax cuts to businesses and high-income individuals are not likely to be very effective for this purpose. The final section briefly summarizes the current benefits and penalties for small businesses in the tax code and general justifications for preferential tax treatment. Given an objective of benefiting small businesses, how well would retaining the top two current tax rates be targeted to small businesses? There are two parts to this question: the fraction of small businesses in the country affected by the tax change (which indicates whether most of the target is being reached) and the share of the tax benefit falling on activities other than those targeted (which indicates how much is being spent on income outside of business). Before addressing these data questions, it is important to recognize what types of business income appear on individual tax returns, especially as subsequent analysis will also focus on the activities of different forms of business organizations. Unincorporated businesses, or businesses taxed as if they were not incorporated, with owners' income subject to the individual income tax, generally operate as sole proprietors, partnerships, or Subchapter S firms. These businesses are also referred to as pass-through or flow-through entities. Sole proprietorships have one owner, while partnerships are businesses with two or more owners. Some types of partnerships have attributes of corporations, mainly limited liability (limited partnerships and limited liability corporations). Finally individuals or partners can operate as Subchapter S corporations, which are incorporated but treated, for tax purposes, as unincorporated businesses. According to data from the Internal Revenue Service, there were 32.1 million businesses in 2007, most of them sole proprietorships. Firms include 1.9 million corporations, 4 million Subchapter S corporations, 3 million partnerships (0.7 million general partnerships, 0.5 million limited liability partnerships, and 1.8 million limited liability corporations), and 23.1 million sole proprietors. While businesses with flow-through income treatment are not all necessarily small, and most corporations are small, these flow-through businesses (proprietorships, partnerships or Subchapter S corporations), for purposes of analyzing tax effects, are treated as a proxy for small businesses in the data presented in this report. In reviewing data on the targeting of these rate cuts, several factors qualify the results of some calculations and are useful to enumerate at this point. The first is that not all high income taxpayers who appear, based on income, to be affected by the rates changes will be, because of the alternative minimum tax (AMT). Some data sources account for this effect and some do not. Because these tax rates are not changing, the significant share of high-income taxpayers who would otherwise pay tax at the 36% or 39.6% rates will pay the AMT and their taxes will not be affected. The second is that a significant share of taxpayers and income at high-income levels are recipients of passive rather than active income. An example of passive income might be rental income as a limited partner in a real estate leasing operation. Recipients of passive income through partnerships and Subchapter S corporations are similar to shareholders of corporations: they do not actively run the business or make hiring decisions. The third is that some businesses experience losses, and there is no income to be subject to tax. Whether calculations include businesses with losses will have consequences for the estimates. Finally, the vast majority of small businesses, almost 80%, do not have employees. Although some limited evidence will be discussed, it is unlikely that a small tax reduction for these non-employer firms would induce these firms to hire. Small business owners would be expected to be relatively more affected by tax rate changes that apply to the top brackets than other taxpayers because they are more concentrated in the higher income brackets than the remainder of the population. Table 1 compares the share of all returns in high income classes (which are roughly equivalent to the taxpayers potentially subject to the top tax rates) to the share of business returns. Business income is reported in two basic categories: income from business or profession, which reflects sole proprietorships, and income from partnerships and Subchapter S firms. As Table 1 indicates, returns for businesses are more concentrated in higher income classes than returns in general, and this effect is particularly the case for partnership and Subchapter S firms. The $200,000 and above adjusted gross income class includes some taxpayers who would not be affected by the President's proposals (because their incomes would not place them in these top rates), which indicates a share of less than 9.6% of small businesses would be affected. As will be shown below, the shares of returns affected subject to the top two rates are also significantly reduced because of the AMT. The shares can also be affected by how returns with losses are treated. The Joint Committee on Taxation, the Department of Treasury, and the Urban-Brookings Tax Policy Center have provided information on the share of returns and income of small business either in the higher-income categories or subject to the top two tax rates. The Joint Committee on Taxation (JCT) estimates that in 2011, 3% of taxpayers with net positive small business income (about 750,000 taxpayers) would be subject to the two top marginal tax rates under the President's proposal. This estimate does not include taxpayers with net losses. JCT also estimates that about 50% of business income will be reported on returns with these marginal tax rates (with aggregate income approximately $1 trillion). This study included income from rents and royalties, and estates and trusts, as well as Subchapter S, partnership, and sole proprietorship business income in estimating shares. A Treasury Study in 2007, prepared for an economic competitiveness conference, had a chapter on pass-though entities, which included data on the share of business income by high-income taxpayers. This study focused on examining high income taxpayers with business income and did not adjust for the alternative minimum tax, so the numbers are comparable to those in Table 1 . As with the JCT study, it focused on returns with positive net income. It included ordinary income from partnerships, sole proprietorships, and Subchapter S corporations, as well as capital gains from partnerships, Subchapter S corporations and estates and trusts. It provided, however, some important information of the effects of including passive versus active income. Some partners or shareholders of Subchapter S corporations are not active business owners. It also provided the share of returns and income in which income was reasonably large relative to wages (thus excluding those taxpayers whose income was a minor part of earnings). As shown in Table 2 , the shares of returns falling in the income ranges of the top brackets are consistent with Table 1 , but neither include the effect of the AMT and, therefore, both overstate the share subject to the two top tax rates.