In the tax portion of last night’s debate, Mitt Romney repeatedly claimed that President Obama will raise taxes on small businesses. “Fifty-four percent of America’s workers work in businesses that are taxed not at the corporate tax rate but at the individual tax rate,” he argued. “And if we lower that rate, they will be able to hire more people.”
Obama replied that 97 percent of businesses who pay individual rates wouldn’t see their taxes go up. But Romney disputed the relevance of that figure. “But those businesses that are in the last 3 percent of businesses happen to employ half — half of all the people who work in small business,” he argued. “Those are the businesses that employ one-quarter of all the workers in America.”
So who’s right? First, the 97 percent figure is if anything an underestimate. According to the Tax Policy Center, in 2011 only 1.4 percent of individual filers reporting “business income” paid the top 33 percent or 35 percent tax rates. The other 98.6 percent either paid the Alternative Minimum Tax (which Obama would replace with the Buffett rule) or else paid taxes at lower rates, which Obama has said he won’t alter.
That said, the 447,000 households paying top rates on business income tend to get more of their income from businesses than those in lower brackets do:
Does this mean 44.5 percent of high-income people own their own small businesses? Not at all. As Derek Thompson explained when this debate popped up two years ago, “business income” could include speaking fees, side income from selling wood carvings, part-time consulting, partnership in a law firm and any number of other activities that most wouldn’t categorize as “owning a small business.”
The Treasury Department had some researchers try to figure out what true small business owners make. It turns out that many of them make nowhere near enough to pay top rates. Only 11 percent of small business owners made more than $200,000, and only 8 percent of small business owners who got at least a quarter of their income that way made that much. Only 4 percent of true small business owners were at the 33 or 35 percent brackets, and would see their taxes go up under Obama.
The portion of small business owners paying those rates goes up if you only look at “employers” — that is, people whose small businesses had labor costs of over $10,000. Of those people, 10 percent paid the 33 percent and 35 percent rates. But given that there were only five million small business owners with employees under this definition, that amounts to 500,000 people getting a tax increase: hardly a huge change.
What about Romney’s claim that businesses with high-earning owners employ more people — 54 percent, by his estimate? This figure comes from Robert Carroll and Gerald Prante at the accounting firm Ernst and Young. But this figure includes all income to “flow-through corporations” — that is, corporations whose profits are passed along to owners and taxed at normal income tax rates. It thus includes flow-through corporations whose owners pay high rates (such as highly profitable software companies), as well as those that pay much lower rates (such as someone with a part-time freelance consulting businesses). Romney very seriously mischaracterized the population to which this number refers.
So will Obama’s tax plan depress hiring among firms organized this way? That’s less clear. Suppose I’m a small business owner who makes $1 million a year and has $200,000 in payroll. If I fired someone making $100,000 in total compensation today, that would increase my income to $1.1 million, and my after-tax income by $65,000, after I take the top rate of 35 percent off.
Now suppose we’re using Obama’s rates. That same firing would only get me $60,400, because of the higher 39.6 percent top rate. So a higher marginal tax rate actually lowers the incentive to fire people and makes hiring look more appealing. Of course, businesses usually hire with the hope that profits go up, and they’ll be less likely to do that with higher marginal rates. But the overall effect on incentives is far from clear.
So Romney is right that some small business owners will pay a higher tax rate under Obama’s plan. But that amounts to only 500,000 people, with only about 652,000 employees. The vast majority of small business owners and employees won’t be affected. What’s more, those who are affected might have more reason to hire.
Note: the original version of this post misread part of a Treasury table to get an estimate of the number of employees affected by changes in individual rates. It appears there isn’t a reliable estimate from a reputable, so that section has been excise. We apologize for the error.