Sunday, December 5, 2010

On Tax Increases and Their Impact on Small Business

The big argument on increasing taxes back to Clinton-era levels is that it will stifle the economy, and the big argument on the mechanism by which it will stifle the economy is that it will prevent small businesses from hiring. I'm sympathetic to both of those arguments, but only up to a point. Let's do a little analysis:

First, let's look at the Obama plan, where we keep the Bush tax cuts in place for everybody making less than $250K a year, and we revert to the Clinton-era schedule for everybody above that.

The first argument made in favor of this idea was that the vast majority of small businesses made under $250K in the first place. I can't compute that number from the data I have (more on this in a moment), but I'm willing to guess that the vast majority of taxpayers who filed a Schedule C, E, or F had incomes under $250K. But note that that includes workers who get paid $8 an hour as contract labor and have to report their 1099's on Schedule C.

So that's not really the question you ask when you're trying to figure out small business impact to the economy. Instead, you want to ask, "what percentage of adjusted gross income came from small businesses whose owners made more than $250K per year? You can find the answer to that question by massaging the data found here. (Excel, but you can look at in Google docs. Also, note that I'm using 2007 data, because 2008 was so disastrous as to be an outlier. The same computations are easy to do for 2008.)

To classify income as "small business income," I'm going to assume that the income (and loss) came from one of the following sources:
  • Business or profession (I think this is Schedule C)
  • Net short-term gain/loss from sale of capital assets (Schedule D)
  • Net short-term gain/loss from partnerships or S-corporations (Schedule D)
  • Net long-term gain/loss from sale of capital assets (Schedule D)
  • Net long-term gain/loss from partnerships or S-corporations (Schedule D)
  • Rent gain/loss (Schedule E, because landlords are running small businesses)
  • Partnership or S-Corporation income/loss (Schedule E)
  • Farm income (Schedule F, I think, because farmers are running businesses, too).
(BTW, this is just an awesome data set--it pretty much tells you everything about how individuals make money in the US.)

When I crunched the numbers, two important stats come out:
  1. 36% of all income for filers with AGIs greater than $200K comes from small business-related activities. (The IRS doesn't have a category break at $250K)
  2. 13% of all US revenue comes from small business-related activities owned by filers who make more than $200K.
13% of the total economy would therefore be affected by letting the Bush tax cuts expire for those with incomes over $250K. (Well, a little bit less, given that the IRS data granularity is for $200K to $500K, but it'll be pretty close.) But the really startling number is the 36% of all revenue for those with greater than $200K. More than $3 out of every $10 made by these people comes from their businesses.

What does this mean? First, note that for income to show up from an S-Corporation or partnership in the individual's AGI, it's got to be profit from that business, not just revenue. It's already been offset by the cost of doing business: buying materials, paying rent on your real estate, cost of utilities, state and local taxes, and, most importantly, the cost of salaries for the business's employees.

So let's now put ourselves in the position of a small biz owner; let's call him Joe. Joe's doing quite well; he's married, he's got a business that returns $185K in profit every year, and he pays himself a $150K salary (i.e., he's his own employee as well as the owner), for an AGI of $340K. Based on 2010 standard deductions and rates, he takes home exactly $250K a year.

Now we'll assume that Joe and his wife have a particular lifestyle, and they want to maintain that lifestyle next year. In other words, Joe will manage his business so that his take-home pays is also $250K a year. With the expiration of the Obama tax cuts, his top marginal rate will go from 33% this year to 38.5% next year, so $90K of his income will be taxed 5.5% more, so he's paying an extra $4950 in taxes. So, he has to pay himself an extra $8182 so that, after the 39.5% taxes on that $8182, he takes home the extra $4950 he needs to maintain his lifestyle.

Joe's got fewer than 10 employees, so he doesn't have to worry about all that Obamacare crap. But, if Joe is paying his employees $12 an hour and they're full-time, 40-hour-a-week employees, each of their salaries is $24,960. Joe has to pay 7.65% in Social Security and Medicare taxes, for an extra $1909, so each employee costs him $26,869. Let's call it $27K.

So the Obama version of the tax increase costs Joe the equivalent of 30% of an employee.

Now, let's say that Joe knows that adding one additional $27K employee will bring in an extra $40K in revenue. (This is a pretty low productivity ratio, but small businesses with low-skill workers are like that. I'm therefore assuming that a big chunk of the productivity of Joe's business comes from Joe himself. Again, I suspect that this is the case, but I haven't done the research.) So Joe gets $13,000 for each new employee that he hires. Even after having to pull another $8200 from the business, the extra employee would make him money--but just barely. And that employee probably can't bring in that money without Joe increasing his capital expenditures. Maybe he needs to buy the employee a desk and a computer. Or maybe he needs to buy another truck for the employee to use to make service calls. When you factor that in, the extra employee is probably a wash at best, and possibly puts him slightly in the red. Bottom line: Joe's not expanding this year.

On the other hand, let's look at another example: let's call him Warren. Warren also runs what would be classified as a small business, but Warren brings in $2M take-home pay. Let's say he pays himself $200K and brings in $2,865,000 in profit. But Warren didn't get to be that rich by being a complete spendthrift; his expenses to support his lifestyle are probably considerably less than $2M. Warren can expand his business simply by saving a little less. Given that Warren is pretty successful, he's probably pretty confident that any expansion of his business is as good or better an investment as dumping his extra money into a mutual fund.

So Warren is unlikely to be bothered much on financial grounds for the tax increase. He may have lots of other things that he's concerned about (Obamacare being high on his list), but you can tax Warren more and he probably won't change his business plans very much.

So there is probably a compromise something like the Schumer compromise, where we jack the highest brackets back to 39.5%, or even 40% or 41%, but move that bracket up to $1M or 1.5M, or even $2M. Figuring out where the break point should be placed is a calculation based on where you think the "truly rich" income begins, with the criterion being those business owners that don't have to maintain their lifestyle at the expense of their business. Using this criterion, it's obviously possible that you bring a trivial amount of new revenue, but my guess is that if the Obama plan at a $250K breakpoint gets 60% of the revenue that going back to the Clinton-era brackets and rates would bring in, then moving it to $1.5M would get you 40%.

The Republicans ought to take a deal like this. Alternatively, they could take a deal where the rates stay where they are today for another year and then go with a Schumeresque compromise written into permanent law with no sunsets. The GOP probably has the votes to ram the whole thing through, but they're going to be on politically shaky ground when the deficit continues to explode. A compromise like this lets them have their cake--growth virtually unfettered by tax-impose deadweight losses--and eat it too, with a substantial deficit reduction.

(BTW, I'm going to claim partial "told ya so" points on how the GOP would play hardball on this issue, based on this post.)

CORRECTION: There was a 36% bracket between $161K and $288K in the Clinton era, so my computation of the extra tax should be $4000, not $4950, which would mean that Joe would have to pull $6611 out of the business, not $8200. I don't think this hurts the overall argument very much.

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