“Despite the president’s claim that tax hikes will only hit those families defined as ‘fortunate,’ the reality is that the tax hike would hit half of all small business income. We need those small businesses paying more employees, not paying more in taxes.”
— Rep. Dave Camp (R-Mich.), chairman of the Ways & Means Committee, April 13, 2011
"The last thing we should be doing is raising taxes on job-creators, entrepreneurs and small business owners across America.”
— Former Massachusetts governor Mitt Romney (R), April 13, 2011
President Obama’s announcement that he wanted to end Bush-era tax cuts for families making more than $250,000 a year earned a predictable Bronx cheer from Republicans. But while Obama frames this as making the rich (such as himself) paying a little more, his opponents have argued that this is an attack on small businesses. That’s a different image, one of struggling mom-and-pop stores unable to hire another employee because of crushing new taxes.
These contrasting images are a perennial in the tax debate, but be wary of numbers when politicians are talking about taxes. Let’s examine how close these statements are to reality.
There are advantages for companies to file corporate income taxes, but there is one big disadvantage — major shareholders are subject to being taxed twice, first on the corporation’s earnings and then on personal income taxes after dividends are distributed to the owners.
So smaller companies, as well as partnerships, sole proprietorships and some limited liability companies, organize themselves differently. The companies themselves do not pay taxes; instead, the earnings or losses are passed through to the shareholders, who then are taxed at the individual tax rate.
When Republicans speak of “small businesses,” they are referring to the companies that file under the individual tax code. But not all of them are what most Americans would consider small businesses — and not all of them are that small, either. In fact, a report by the Joint Committee on Taxation — the nonpartisan congressional entity that ‘scores” tax legislation — found that the number of tax returns by so-called “flow-through entities” has soared in recent years.
As of 2005, the JCT says, retail trade (such as mom-and-pop shops) accounted for about 11 percent of so-called S corporations, holding 12 percent of total assets, and 5 percent of partnerships, with less than 1 percent of total assets. Another 14 percent of S corporations were in construction but the largest category, at 15 percent, were “professional, scientific and technical services.”
Some of these “pass-through” companies are rather large, with revenues of more than $50 million, but they represent just a small proportion of such companies. According to calculations by Donald Marron, director of the Urban-Brookings Tax Policy Center, in 2008 such companies accounted for less than one-tenth of one percent of all returns filed — but they had 40 percent of revenues and 30 percent of all profits.
“Large businesses thus account for a large share of the economic activity pass-through entities undertake,” Marron recently told Congress. “Policymakers should therefore take care not to equate pass-throughs with small business.”
The result, according to the Joint Committee on Taxation, is that only 3 percent of all “small businesses” paying taxes would be affected by Obama’s plan to lift marginal tax rates on families making more than $250,000 and individuals making more than $200,000. (See page 25 of the JCT report.) That group — about 750,000 taxpayers — accounts for 50 percent of the estimated $1 trillion in business income reported in 2011. The other 97 percent of “small businesses” shared the rest — and under Obama’s plan, they would get to keep their Bush-era tax cuts.
Now let’s look at the statements of Camp and Romney.
Camp said: “The reality is that the tax hike would hit half of all small business income. We need those small businesses paying more employees, not paying more in taxes.”
Romney said: "The last thing we should be doing is raising taxes on job-creators, entrepreneurs and small business owners across America.”
Romney spokesman Eric Fehrnstrom made no effort to claim many businesses would be affected. As he put it, “A number of small-business owners file taxes through the individual income tax code, and the tax hikes President Obama is proposing would affect these job creators and entrepreneurs.”
Michelle Dimarob, a senior adviser to the House Ways & Means Committee, noted, “We didn’t talk about the number of small businesses, but about the level of income. I could understand if we said half of all small businesses with no reference to the income. That would be misleading and inaccurate, but we didn’t.”
She added, “Regardless of whether or not it is 3 percent doesn’t change the fact that those businesses (by percentage (3 percent) or amount (750,000 taxpayers)) are reporting business income on individual returns, and that income accounts for half the income reported at those levels.”
In Dimarob’s view, “That income is critical because it means those businesses — whether they are bakeries, law firms or otherwise — are providing jobs to people. If taxes go up, then they will have less income to provide jobs and pay people.” She concluded: “This is not worth a couple Pinocchios — it is worth zero Pinocchios.”
The Pinocchio Test
We understand the philosophical argument against imposing higher marginal rates and appreciate the careful nature of Camp’s and Romney’s statements. But we still have trouble with the emphasis on “small businesses.” The data is a bit obtuse, but the big money is being made by a relatively small group of companies, law firms and the like — many of which are rather large.
We are willing to give Romney a pass, because he did not place a number in his statement; taxes would indeed need to be raised on some entrepreneurs and job-creators, though maybe not many “small businesses.” But Camp referred to “half of all small business income.” The income figure is correct, but the phrase “small business” would be misleading to people who are not experts in the tax code.
Update, 12:30 PM
We received some interesting letters from readers, who from personal experience questioned the idea that higher taxes would make much of a difference in whether to hire new employees. Here are some excerpts. Perhaps others have another perspective. Feel free to comment or send us an email:
Income that passes through to owners is what would get taxed more heavily.Income that stays in the business, and is used to pay new employees, etc., is not taxed at all for the owners. It’s fully deductible when used for business expenses, such as employee wages.
A higher personal income tax rate is an *incentive* to hiring more people and investing more in a business to make it grow, because you’re leveraging pre-tax money. This is especially true so long as capital gains rates remain low, bringing the promise of a low-tax payday in the future when you cash out of a now more-valuable business.
This is precisely the impact that personal taxes had on me in my years of small business ownership. I invested more in my business, especially as tax day drew near, because the alternative was giving a big slice of the money to Uncle Sam.
Regarding today’s column, one other important point should be made. Small businesses, whether taxed at individual rates, as pass through entities, or at corporate rates, do not look at income tax obligations and decide whether they can afford to hire another employee. The tax savings from lower rates, certainly increase the bottom line, but a company decides whether to distribute its profits, pay down debt, or reinvest in the company. Some of these, particularly an investment would involve capital investment, research and development, etc., may lead to all of greater employment down the road at the company. But this is an indirect result of any tax savings.
I find it hard to believe, that a company looks at the tax savings, and decides it can hire another employee. An employee is a cost necessary to produce revenues, not typically an investment. If the company thinks the employee will contribute to greater revenues, because it can meet more demand or generate more demand, it will hire the employee. If the company is correct, the cost of the employee (salary and benefits) the additional revenues over the increased salary/wage/benefit costs result in additional profit. Incidentally, the cost of the employee is expensed, so if it is a wash, there is no tax impact. If it is a net loss, even less tax is paid. If there is a profit, more tax is paid, but the company still comes out ahead. The tax rates are not particularly relevant. In fact, hiring more employees, increasing the expense of the workforce might be the ironic result of higher rates. It is not difficult to imagine an entrepreneur concluding that he or she does not personally benefit that much from making additional profit (if too rates are too high), and is willing to try something else (hire an extra worker) that reduces profit, just to see what happens.
Now, I understand, that an entrepreneur may not want to take on additional risk, (e.g. invest in expansion), if he or she believes higher tax rates will adversely impact the economy, or if the rates are so high, that he or she sees little incentive to making the extra profit. But, I am not aware that any of my business clients have decided that because the tax burden is too high, the business enterprise cannot afford to hire another employee. The reason not to hire employees, or let employees go, is because either business and sales are not strong enough, the company can meet demand with a lesser workforce, or there is no need to do so generally. Although employers are often loyal to their employees and try to keep them on in bad times out of loyalty and for altruistic reasons, I have never seen a new hire occur because the employer has a little extra cash to spend.