Taxing Small Business

William H. Young

As government in Washington addresses the year-end “Fiscal Cliff,” the effect of possible tax increases on wealthier individuals who also own small businesses and file business and personal income together on individual tax returns has again taken center stage because of concern for adverse impacts on still-slow economic and job growth. Today, the argument revolves around the 3 percent of small businesses who would see their owners’ tax rates rise.

President Obama insists on raising high-end marginal tax rates on incomes over $250,000 per year in extending the Bush tax cuts, arguing “that means that 98 percent of all Americans and 97 percent of all small businesses won’t see their taxes go up a single dime.” (The White House, Remarks by the President in a News Conference, November 14, 2012) More accurately, Mr. Obama’s proposal calls for tax rate increases on individual incomes over $200,000 and household incomes over $250,000.

Earlier in 2012, The White House Blog explained that

Even using an overly broad definition of who is a small business owner (a definition that includes passive investors and highly compensated lawyers and hedge fund managers), today’s proposal will extend all of the…tax cuts for 97 percent of all small business owners….This has been confirmed by the independent Congressional Research Service…

(Amy Brundage, “Extending Middle Class Tax Cuts for 98% of Americans and 97% of Small Businesses,” July 09, 2012)

But an Editorial by Investor’s Business Daily (“Obama Tax Hikes on Rich Would Shrink Economy, Jobs,” November 14, 2012) presents a different take on the 97 percent:

This is, to put it mildly, deceptive. By jacking up taxes on the most successful 3% of small businesses, Obama will destroy hundreds of thousands of jobs, shrink U. S. output and force companies to raise prices….America has some 34.8 million small businesses, according to a recent Treasury Department study….30 million of them employ no one other than the owner. Of the remaining 4.8 million that do employ workers, 1.2 million have incomes above $200,000—where Obama’s tax hikes kick in.

Here’s the rub. Those 1.2 million small businesses that will be hit by Obama’s small-business tax are the nation’s most prolific job creators, accounting for 54% of all private-sector positions—or 77.6 million in all. And while they make up just 3% of small businesses, they earn 91%--or $341 billion—of all profits reported by the small businesses with workers….

The Editorial also notes that a study by the consulting firm Ernst & Young released in July 2012 (“New Study: Higher Tax Rates Will Hurt Economy, Small Businesses,” National Federation of Independent Business, July 17, 2012) concluded that “Obama’s tax hikes will:

  •     Slice 1.3%, or $200 billion, from the nation’s GDP.
  •     Kill 710,000 jobs immediately, with a projected 0.5% cut in long-run employment.
  •     Shrink capital stock by 1.4% and capital investment by 2.4% over the long run.
  •     Slash real after-tax income by 1.8%, further reducing Americans’ standard of living.”

The Editorial goes on to argue that “knowing all this, calls for Republicans to ‘compromise’ on taxes should be taken for what they are: an attempt to get the GOP to collude with Obama and Democrats in the dismantling of our small-business sector.”

Back in 2010, when the same tax increases were under discussion, economists Alan D. Viard and Kevin A. Hassett of the American Enterprise Institute argued (“The Small Business Tax Hike and the 97% Fallacy, The Wall Street Journal, September 3, 2010) that

The sound bite about 3% of small businesses, which has been picked up by numerous pundits, is one of the more misleading statements in the long history of economic propaganda. The 3% figure, which is computed from IRS data, is based on simply counting the number of returns with any pass-through business income….The fact that there are millions of people in the lower tax brackets with small amounts of business income…is irrelevant for the assessment of the economic impact of the tax hike.

The numbers are clear. According to IRS data, fully 48% of the net income of sole proprietorships, partnerships, and S corporations reported on tax returns went to households with incomes above $200,000 in 2007. That’s the number to look at, not the 3%.

Time and the outcome of the 2012 election have not changed the basic economic impacts of increasing the marginal income tax rate on small business owners with incomes over $200,000 who file taxes as individuals rather than corporations, which I explained in Taxation. But there are some additional professional and public opinions about that tax issue.

Democrat investment banker Steven Rattner (who managed the auto industry bailout for President Obama) recently offered a Wall Street perspective on potential alternatives to raising the marginal income tax rate. (“More Chips For Tax Reform,” The New York Times, November 24, 2012) He suggests returning the capital gains tax rate to 28 percent (the value in the Tax Reform Act of 1986 signed by President Reagan); eliminating “carried interest” for private equity and hedge fund investors (also discussed in Taxation); and limiting the total amount of tax deductions for the wealthy (which Republicans support as well).

Democrat investor Warren Buffet affirms that raising the capital gains tax rate would not inhibit investment. (“A Minimum Tax for the Wealthy,” The New York Times, November 25, 2012) Moreover, he shows that, ironically, raising upper-end marginal income tax rates would have little effect on the superrich, though he supports such a change—with a cutoff point of “maybe $500,000 or so.” He proposes a minimum tax of “30 percent of taxable income between $1 million and $10 million, and 35 percent on amounts above that.” This would “block the efforts of lobbyists, lawyers, and contribution-hungry legislators to keep the ultra-rich paying rates well below those incurred by people with income just a tiny fraction of ours.”

In a Quinnipiac poll last week (“U.S. Voters Trust Obama, Dems to Avoid Fiscal Cliff, Quinnipiac University National Poll Finds; Tax the Rich, But Don’t Touch Medicare, Voters Say,” December 6, 2012), voters strongly supported imposing higher taxes on households with incomes above $250,000 per year—by a margin of 65 percent to 31 percent. Voters in all but one category—Democrats, Independents, men, women, whites, blacks, Hispanics, young, old, and all income levels below $250,000—supported higher taxes by margins of more than 60 percent. Only Republican voters opposed the rate hikes, by 53 percent.

In that same poll, only 47 percent of voters supported increasing the capital gains tax rate on money earned on investments, while 40 percent were opposed. Again, nearly all categories of voters expressed opinions like the whole, while 61 percent of Republicans opposed raising the capital gains tax rate.

This is puzzling since the superrich—the principal source of the income gap between the rich and poor and the inequality so loathed by progressives, especially academics—uniquely earn most of their income as capital gains from corporate investment. As Warren Buffet notes, raising marginal tax rates on ordinary income would have little effect on the superrich. And raising the capital gains tax rate, as Steven Rattner suggests, would not affect small businesses whose owners file as individual taxpayers (though it would affect corporate businesses).

To consider what might be a reasonable tax compromise—avoiding going over the Fiscal Cliff while still preserving badly needed jobs and economic growth as well as raising revenue equitably—one needs to look beneath and beyond President Obama’s rhetoric about taxing only 3 percent of small businesses. But, then again, for him it is primarily about redistribution and fairness, as I showed in Equality and Governance, an argument that the public other than mainly Republicans seems to be accepting—without adequately appreciating the consequences. Unfortunately, symbolism seems to have trumped sound public policy.

Next week’s article will consider why President Obama has been so successful in winning support for raising tax rates on the rich.

______________________________________________________________________________

This is one of a series of occasional articles applying the lessons of Western civilization to contemporary issues relevant to the academy.

The Honorable William H. Young was appointed by President George H. W. Bush to be Assistant Secretary for Nuclear Energy and served in that position from November 1989 to January 1993. He is the author of Ordering America: Fulfilling the Ideals of Western Civilization (2010) and Centering America: Resurrecting the Local Progressive Ideal (2002).

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