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.
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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.
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Comments:
The small business owner (who is successful in this case) will always find ways to legally write-off and reduce tax liability if the taxes were raised. So, government always tries to focus on what-ifs when they raise taxes on the rich. That's like trying to plan for a race to beat a cheetah. The affluent business owners who make the most money will always be one step ahead, finding loopholes.
OMG, you are going to debate his point by using Paul "destruction is good for business" Krugman?!!! Seriously, you're the one who ought to be embarrassed.
It appears that none of the commenters up to this point understand how most small businesses are taxed. The typical small business is organized as a "pass-through" entity (Sub-S, LLC, LLP, etc.). At the end of the year, the owner receives a K-1 showing how much the company made (or lost). Many successful small businesses have a net profit of more than $1MM in a particular year (and possibly a loss the following year). So, if a CEO of a small business that has a $1MM net profit earns a salary of, say, $200K per year, the total taxes owed by the owner would be based on income of $1.2MM. Generally, the net profit of the company is retained as working capital (for expansion, new hires, and to too ensure there is enough cash to continue to operate without laying off employees). In this example, assuming an effective tax rate of 28%, the total tax owed by the owner would be $336,000 -- $136,000 MORE than the owner's salary. That $136K has to be paid from the business's working capital. Raising the rate would mean even less working capital. There is a fairly simple solution: exempt from net taxable income of small businesses an amount of working capital equal to 24 months payroll costs (excluding owner's payroll). That would accomplish two things: 1. Incentivize small businesses to hire more employees so they can retain more working capital (and expand). 2. Maintain the existing tax rates on high income taxpayers who don't create jobs while not penalizing those who do. IOW, taxes on high paid athletes, entertainers, wall street brokers, etc. would not be reduced.
I respectfully disagree with your conclusion. If a small business owner pays a 3.25% surcharge on annual income of $1,500,000, you're talking about $16, 250 in additional taxes. Assuming there are no other deductions, that leaves the small business owner with a net of $1,133,750 after ordinary taxes and the surcharge. And you purport that this will damage the person so much that employees would lose job? This is preposterous.
But if this tax is on personal income, then that money was going into their private bank accounts anyway, not staying in the company. Furthermore, you cannot state that reducing taxes boosts economic growth without reference to the current level of tax. Because otherwise you are implying ALL tax reductions would boost growth, meaning the optimal tax level would be zero. Which it would certainly not be. The reason this obviously wrong conclusion is reached is because the 'calculation' does not include what the government does with this additional tax revenue. Do they use it to pay down debt? Is it invested in infrastructure? Is it given away as social security? Scientific research? Military spending? Policing? Foreign aid? Education spending? Each of these will affect growth differently. The real question is how does what the government spend the money on compare to what the private company would have spent it on. Would they have invested? Employed more people? Or would have it gone on a new Ferrari? As always, the devil is in the detail.
Krugman also advocates massive printing of money to increase inflation, and massive "stimulus" spending to boost the economy. He is a smart man, yet a complete fool. Stuck in Keynesian mentality, creating economic bubbles and striving for egalitarianism, not liberty.
Paul Krugman isn't an expert. Experts usually get their predictions right most of the time. If you're constantly wrong, I have news for you. You aren't an expert in economics.
Nonsense. Paul Krugman (an authority on such matters) called your main source in this article "not a reliable source." He also accused them of "deliberate fraud" in the New York Times... That's embarrassing. Frankly, your editors should write an apology for this trash.