Does raising taxes on the rich hurt small businesses?

As I wrote yesterday, the policy disagreement animating the "you didn't build that" argument is a relatively narrow one: The question is whether we should increase tax rates on the rich to fund public investment. One argument against that proposal is that, since some small businesses end up paying taxes as individuals, higher tax rates on the rich mean higher tax rates on small businesses, which means fewer people will build firms.

The Center on Budget and Policy Priorities has a policy brief that attaches some numbers to this argument. The key points:

1) Relatively few small businesses would be affected. "Allowing the top two marginal tax rates to return to pre-2001 levels as scheduled next year would affect very few small businesses, a recent Treasury Department study found. The study shows that only 2.5 percent of small business owners face the top two rates."

2) There's little historical evidence that cutting taxes on the rich leads to better performance among small businesses. "The arguments against allowing the high-end tax cuts to expire on schedule echo those made against President Clinton’s proposed 1993 tax increases, which set marginal rates at the levels to which they are set to return when the Bush rate cuts expire.  Critics claimed at the time that those tax increases would seriously harm economic growth and even send the economy back into recession.  As it turned out, job creation and economic growth proved significantly stronger following the 1993 tax increases than following the 2001 Bush tax cuts.  Further, small businesses generated jobs at twice the rate during the Clinton years than they did under the Bush tax code."

Center on Budget and Policy Priorities

3) Cutting taxes on small businesses is not likely to increase their hiring. "Until they see a pickup in sales, businesses with excess capacity are unlikely to use the proceeds from any tax cuts to hire more workers or expand capacity further. This is why CBO, even as it has noted that some businesses would profit from an extension of the current top tax rates, rejected the argument that Congress should extend these tax cuts to create jobs in a weak economy: 'Increasing the after-tax income of businesses typically does not create much incentive for them to hire more workers in order to produce more, because production depends principally on their ability to sell their products.' "

4) We should worry about young firms more than small firms. "There is an emerging consensus among economists that young small firms — not small firms in general — are particularly important 'job creators.'  A 2010 study finds no systematic relationship between firm size and job growth, after controlling for firms’ age. It thus is important to distinguish between startup businesses, which the study finds 'contribute substantially to both gross and net job creation' (as well as to gross job destruction when they fail, as many startups do), and other small businesses, which on average generate no more net job growth than do larger businesses."

More generally, if we nevertheless decide we want to cut taxes and ease burdens on small businesses, or young businesses, cutting taxes on all high earners is not a cost-effective way to do it. Some better ideas can be found in this proposal from Carl Schramm and Robert Litan, including:

Let's change our tax code to facilitate the financing of small business, with a permanent capital gains exemption on investments in startups held for at least five years and a significant cut in corporate tax rates for new companies in the first three years they have taxable income.

To make it easier for growing private companies to go public, let's give their shareholders (who can best judge the benefits and costs of financial auditing mandates) and those of other public companies with a market cap of $1 billion or less the choice whether to comply with the onerous requirements of the Sarbanes-Oxley Act.

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