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The Fiscal Cliff Deal and Small-Business Job Creation

January 8, 2013
URL: http://www.entrepreneur.com/article/225433

While Wall Street, Washington politicians and a slew of pundits have hailed the last-minute compromise on the fiscal cliff, the deal isn’t good for small-business employment, historically an important source of job creation.

Economists worry about how legislation affects small-business hiring because companies with fewer than 500 employees account for roughly half of all private-sector employment, the U.S. Small Business Administration reports. Moreover, how legislation affects small-business owners’ hiring plans is particularly important now that the vast majority of owners have expressed a reluctance to add workers.

While the fiscal cliff deal has many merits (which have been described elsewhere by others), three of its major components discourage small-business job creation: the end of the payroll-tax holiday, higher marginal tax rates on the wealthy and the increase in capital-gains tax rates.

Related: What You Need to Know About the Fiscal Cliff Deal and Saving Taxes in 2013

The most straightforward negative effect lies in the termination of the payroll-tax holiday that had reduced the employee’s share of Social Security tax from 6.2 to 4.2 percent of wages. While this isn’t specific to small businesses, the pattern is clear: Payroll-tax cuts stimulate job creation and payroll-tax increases discourage it. Joel Prakken of Macroeconomic Advisers estimated that the payroll-tax cut added 300,000 jobs to the U.S. economy. Therefore, doing away with the payroll-tax cap should eliminate 300,000 jobs.

The cliff deal will also lower small-business job creation by raising the marginal tax rate on the highest earning Americans. Under the deal, the marginal tax rate on single people earning more than $400,000 a year and married people earning more than $450,000 will rise from 35 percent to 39.6 percent. In addition, these earners face a 0.9 percentage point increase in the Medicare tax. The highest-earning small-business owners will be facing a federal marginal tax rate on business income that is 5.5 percentage points higher in 2013 than it was in 2012.

That tax increase will affect small-business owners’ willingness to employ others. Research by economist Robert Carroll (now of the Tax Foundation) and colleagues showed that a one-percent decline in small-business owners’ “net of tax” fraction of income lowers their probability of hiring by 1.2 percent. Therefore, the tax increases that wealthy small-business owners now face should translate into a 6.6 percent decline in their probability of hiring.

Related: What Entrepreneurs Need to Know About What's Ahead in 2013 for the U.S. Economy

While some shrug off this effect, arguing that it impacts only a tiny sliver of small-business owners, this argument ignores the disproportionate employment by high-income small-business owners. Analysis of the Federal Reserve Survey of Small Business Finances by George Haynes of Montana State University reveals that the small-business owning families who earn more than $250,000 per year employ 93 percent of the people who work in small companies.

A final part of the fiscal-cliff deal involves a 5 percentage-point increase in the capital-gains tax rate imposed on the highest earners. This provision will reduce the amount of equity financing flowing to small companies. By cutting the after-tax take of equity investors, Congress has lowered the incentive of investors to provide financing. At the margin, some companies that would have attracted angel and venture-capital investment in 2012 will not be able to get financing in 2013. While only a small number of companies will lose out on this investment -- angels and venture capitalists tend to finance relatively few U.S. businesses -- those companies tend to generate a disproportionate number of jobs.

While a few provisions in the bill benefit small-business owners, such as the research-and-development tax credits, and bonus and section 179 depreciation deductions, these terms affect too few small-business owners or have too small an impact to offset the negative effects of the primary parts of the new law.

Whether the deal to avert the fiscal cliff should have been made depends on a multitude of factors, including the effect on business confidence, averting another recession and getting the folks in Washington working together to solve America’s economic problems. But from the narrower perspective of small-business employment, the assessment is negative. The deal reduces the incentive for small-business owners to hire in 2013.

Related: Fiscal Cliff Worries? Starting a New Business Could Be Your Best Tax Option