The State of During Fiscal Year 1976 the Federal Government and the small business community reviewed the long-range problems of small companies, focusing particularly on basic requirements of small firms for adequate investment funds and profit. This emphasis was timely and in keeping with overall efforts of the Administration to improve capital formation prospects of the private sector. It was evident during the year in both enacted and proposed legislation. Tax Burden Given Attention Many provisions of the Federal tax code are adverse to the operation and continuation of small firms, and the Small Business Administration, the Administration, the Congress and the small business community proposed numerous changes to correct these biases. Areas of particular SBA interest, which also received broad support from other sectors, included revision of the corporate and estate tax structures. Changes in the corporate tax structure to permit small businesses to retain more of their profits would aid small firms in meeting their capital needs. Small corporations seldom raise equity capital from the sale of their stock. Less than one percent of the corporations in the U.S. are publicly held. A study based on recent corporate data showed that approximately 90% had less than $1 million in business receipts, a full half had receipts under $100,000, and over one-third had receipts under $50,000. The financing problems of most of these small corporations are quite similar to those of sole proprietorships and partnerships. Their shareholders depend heavily on their own and family investment for initial capital and on retained earnings, bank loans and trade credit for funds for growth and operations. Higher Surtax Exemption Supported Under prevailing tax law the combined normal and surtax rate of 48% is reached at the $25,000 income level, except that currently this is temporarily raised to $50,000. Such a level, as viewed by the President, the Treasury, SBA, and a substantial body of other tax opinion, is too low to allow small business to accumulate sufficient earnings for present and future capital needs. In FY 1976 SBA supported the Administration's recommendation to increase the surtax exemption to $50,000 from $25,000 as a permanent measure and to reduce the normal tax on the first $25,000 of net taxable income to 20% from 22%. These changes would permit small corporate firms to retain more aftertax dollars for operating capital, for growth, and for making necessary improvements in plant and facilities, including the installation of safety provisions, pollution abatement facilities and other mandatory requirements. This type of tax reform is needed to enable small corporations to rely more heavily on retained earnings as an effective source of capital. Small corporations are unable to obtain long-term financing to the same degree as large firms and, therefore, have a larger proportion of their debt in short-term Percent 40 30 20 10 loans. This situation is particularly adverse to small concerns as it makes planning for future operations and profit extremely uncertain during periods of increasing inflation and rising interest rates. Figures for all short-term and longterm debt are not available, but small manufacturing corporations for the first three quarters of the year showed a higher proportion of short-term loans to long-term loans than larger firms (Chart 1). Double Taxation of Dividends The SBA supported the Administration's proposal to eliminate the double taxation of corporate income, once under the corporate income tax and again under the individual income tax. This tax reform is needed to improve the after-tax return to capital and thereby provide needed inducement for increased saving, capital formation, and investment. Such a measure would be particularly helpful to the owners of small, family type corporations which generally are less able to shift the incidence of the corporate tax than larger public corporations. Another pressing need for this tax reform is to eliminate the existing tax bias against equity capital in favor of debt financing, thereby removing tax induced pressures for this capitalization and illiquidity of corporate business. 70 60 50 Average Percentage of Long-Term Loans (Manufacturing Corporations) Capital Gains Tax Revision The SBA also supported the Administration's proposal to tax capital gains under a declining rate structure-rates which decline with the length of time over which investments are held before gains are realized. Such a measure is needed to unlock huge amounts of capital investment and free this capital to flow into its most productive employment, thereby increasing the availability of capital for investment in promising small business ventures. Estate Tax Reforms Another item of the SBA tax package with major significance to small business was the proposed revision of the estate tax law. Current estate tax law incorporates outdated and unrealistically low exemption levels which often force small business heirs to sell, liquidate, or merge these enterprises in order to pay estate taxes when a principal or sole owner dies. In recent years this has become a growing problem for farm families, as well as for small business owners, as land values have increased and the size of farms has become larger. To alleviate these adverse circumstances, SBA supported the Administration's proposal to increase the personal exemption to $150,000 from $60,000. It also recommended that deductions allowed for a surviving spouse's interests, as an heir in an estate, be increased to 100% from 50%. It further recommended more lenient terms for heirs of farms and small business persons to pay estate taxes in instances where a substantial portion of the estate is comprised of a farm or an interest in a small business. Assistance to Small Farms Enactment of P.L. 94-305 in June opened an additional possible source of financial and other assistance for small farmers from SBA. The legislation removed the traditional distinctions between small farms and small nonagricultural concerns as business undertakings operated for profit and made small farms, which had been largely excluded from SBA assistance previously, eligible for all SBA programs, including loans. Between 1950 and 1976 the number of operating farms declined by more than one-half and the average farm acreage increased by 80%-85%. During these years farming continued to change dramatically from a labor intensive to a capital intensive undertaking, and the financial and operational requirements of farms became quite similar to those of small nonagricultural businesses. Use of larger parcels to cultivate in conjunction with rising land values has greatly increased the capital needs of farms. Another requirement of long-term financing is the complex, expensive machinery, which is used extensively on larger acreages. 13.2 Million Small Businesses Based on Internal Revenue Service statistics for the latest year computed, 1973, there are approximately 13.6 million businesses in the U.S., including 3.3 million farms. By SBA's definition, 97% of these businesses are considered "small", or 13.2 million. The net gain of small businesses over the previous year was approximately 600,000 businesses, a 4.5% growth. At the close of FY 1976, detailed information on the size distribution of agricultural concerns was not complete, but if small farms represent a substantial portion of the total agricultural, forestry and fishing sector, they may constitute the largest industry division of small business, as shown below: In general, small business benefitted from Federal efforts to stimulate economic activity and control inflation. The Tax Reduction Act of 1975, frequently cited as a key factor in the recovery, provided substantial rebates on the 1974 personal income tax and tax reductions, particularly for low-income individuals, which increased the effective purchasing power of consumers. Consumer confidence improved markedly, and during the first three quarters of FY 1976 personal consumption expenditures were the force of the recovery. Retail sales and manufacturing profits of small corporations improved. Monetary policy, which alternately contributed to and restrained demand, did curtail the rate of growth of inflation and brought a general decline in shortand long-term money market rates through the first three quarters. In the fourth quarter, the rates generally rose again but did not reach their levels of the first half. These changes were accompanied by improved investment prospects in the stock market, and large firms turned to large, money center banks and to equity markets for a greater portion of their financing needs. The availability of funds for small borrowers who depend heavily on business loans from the smaller banks appeared to increase. This, at least, is indicated by the substantial increase in the number and amount of SBA guaranteed bank loans to small business. Slow Construction Improvement Despite improvement in the availability of mortgage money during FY 1976, housing construction, in which small general and special trades contractors are involved significantly, did not respond in as robust manner as had been expected. Housing starts improved over the previous fiscal year, but the improvement was highly concentrated in a few fast growing metropolitan areas. mostly in the South and Southwest. Generally, the continuing high cost of homes, land values, and mortgage money was a drawback to the construction industries. Some of the fiscal stimulants to the economy probably were of limited help to small business also. The Tax Reduction Act of 1975 had included an increase in the investment credit to 10% from 7%, but that did not trigger a new round of capital spending. In manufacturing, utilization of productive capacity continued to be low, prices of capital goods remained high, and the outlook for economic recovery was less certain in the early part of the year, a period when capital spending plans most often are made by business. Also, more than onehalf of all small firms are in the labor intensive retail or service-producing industries where purchases of depreciable property, which qualify for the investment credit, are more limited than in the capital intensive goodsproducing sector. For these reasons, most small firms may not have benefitted extensively from the investment credit provision of the tax law or at least did not benefit to the same degree as large firms. Availability of Loans Short- and long-term interest rates on business bank loans of under $500,000, the size category encompassing small business borrowing, generally declined. Average short-term rates on loans under $10,000 dropped from over 9% in August, November, and February to 8.91% in May. Rates on loans of $10,000$99,999 fell from over 9% in August and November to 8.4% for February and May, and the loans of $100,000 to $499,999 declined 70 basis points from 8.48% in August to 7.78% in May. For each loan size category under $500,000, longterm rates showed declines (Table 1). Despite improvement in the supply and cost of funds, business bank loan demand remained weak throughout much of the year. Not until the latter half of the year did the volume of short-term borrowing increase when loans of under $100,000 rose 6.9% in February and another 7.4% in May. Business bank loans of $100,000 to $499,999 increased 12.8% in May for the first time since November 1974. The volume of long-term business bank loans of under $100,000 increased 29.3% in the last quarter of FY 1976. The demand for the same type of longterm loans of $100,000 to $499,999 declined 12.3% from an exceedingly high increase in February. Finance companies are rapidly becoming a relatively more important source of |