Guest op-ed contributor Scott Shane is a professor of entrepreneurial studies at Case Western Reserve University. He writes about entrepreneurship and innovation management, among other things.
The Obama administration misunderstands how to help small businesses drive economic growth and employment because it assesses the impact of tax increases on small business with political rather than economic measures. A recent blog post by Assistant Treasury Secretary Jenni LeCompte focuses on the number of small business owners who would be affected by a tax increase rather than the impact on small business economic activity.
LeCompte explains that roughly 1 percent of small company owners would have to pay a proposed 3.25 percent tax increase on incomes in excess of $1 million, citing a recent paper by Treasury’s Office of Tax Analysis. That makes the surcharge good politics: 99 percent of small business owners won’t be affected. If they vote their pocketbooks, then the proposed tax increase wouldn’t sacrifice many votes.
However, the number of small-business owners affected by a tax is the wrong measure if you are concerned about its effect on economic activity. To assess that, you need to know how the tax affects the employment and economic growth that small businesses generate.
Indeed, much research has concluded that tax increases have a negative effect on small business employment and investment. A study by Robert Carroll, formerly of the Treasury Department’s Office of Tax Analysis and now with the Tax Foundation, and colleagues shows that each 10 percent reduction in small-business owners’ after-tax personal income reduces the odds that their companies will add employment by 10 percent. Another of his papers reveals that a 1 percent rise in small-business owners personal tax rate is associated with a 10 percent decrease in capital investment.
Because of the way capitalism works, the proposed tax surcharge will affect a much larger amount of small business economic activity than the tiny fraction of small business owners it will hit. It’s really quite simple: Small-business owners who make more money tend to hire more people and contribute more to GDP than those who earn less.
How much would small-business hiring suffer if the surcharge were imposed? We don’t have employment data based on the earnings of small-business owners. But related data suggest it’s a lot more than the 1 percent.
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My back of the envelope calculations show that about one-fifth of all private-sector workers are employed in small-businesses whose owners could be hit by the surcharge. To reach that conclusion, I assume that small businesses whose owners earn more than $1 million per year have at least $5 million per year in sales but no more than $45 million. And Census data show that 19 percent of the private-sector labor force worked for businesses with between $5 million and $45 million in sales in 2007, the latest year data are available.
If you want to judge the true impact of the tax, you need to consider the most telling measure. Instead of the number of small-business owners affected, think about the many people who work for them who would be hurt by the tax. That number is surely substantially larger.