Marginal Income Tax Rates and Small Business: The Economics of the “Stupid Party”

John Boehner today again argued against returning to the top marginal income tax rates of the prosperous Clinton era (themselves relatively low by historical standards) by referring to their supposed negative effects on “job creation” by small businessmen.   Though the real-world economic effect is likely to minimal, there are sound arguments from economic theory that the increase might actually create jobs.

Labor costs are subtracted from business income before arriving at the profit that might then be taxed, whether at corporate or individual rates.   Workers are not hired out of a business’s profits, they are hired using before-tax cash.   If the small business is not making a profit,  a (unitary) small business owner is not paying the top tax rate, and this is all irrelevant.    So hiring a worker is something a profitable small business owner can do to reduce its exposure to tax.   It will create more firm value for the future, so if the small business owner later sells (and realizes value that is taxable at lower capital gains rates), the effect will be to have avoided the income tax now to pay lower capital gains tax later.   Even if they pay income tax on increased profit later, the tax will have been deferred.  So economic theory says that a higher marginal tax rate will be an extra incentive to avoid realizing profits now, especially if it can be turned into a capital gain rather than ordinary income later.

If the small business person has an after-tax income target that they are trying to meet, then a higher average tax rate will require more profits to reach this target, so in fact increasing both marginal and average rates may be better (so eliminating deductions might actually be worse than increasing marginal rates — and not just because of the fairness issue that cutting deductions favors the super-rich compared to the merely rich, or because many mechanisms for recapturing deductions create a “bubble” of higher marginal rates for a certain income segment).

In the real world all of these marginal incentive effects are small, certainly in regards to the difference between 36 and 39.6%– so the talk of incentives is  really an academic discussion– the major point is that Boehner and others who talk about higher individual income tax rates as a disincentive to hire workers are flat wrong just because labor costs come from pre-tax firm funds, not after-tax funds.

Comments

  1. Byomtov says

    So hiring a worker is something a profitable small business owner can do to reduce its exposure to tax. It will create more firm value for the future, so if the small business owner later sells (and realizes value that is taxable at lower capital gains rates), the effect will be to have avoided the income tax now to pay lower capital gains tax later.

    But this identifies one reason that a higher rate might discourage some hiring. The new worker must be paid today, while the additional profit comes later, and that profit is not guaranteed. So the new hire is a risk, and the increased tax rate reduces the payoff if the company wins the bet.

    The second point, which sounds like a labor/leisure argument, is stronger, but I don’t think it’s necessary to rely on either to claim that Boehner&Co. have a weak case. The fact that labor costs are pre-tax, as you point out, is important. So is the fact that not that many small businesses will even be affected.

    The relevant cutoff point is not a vague “$250K.” It’s enough profit, not revenue, that the taxable income of an owner is $250K. Remember, it’s the owner(s), not the business, who is taxed, and then the higher rate only applies to taxable income over the $250K threshold. So, assuming a single owner, the business likely has to generate $300K or more in profits before the owner has to pay the higher rate. But of course, once businesses get to be a certain size, they tend to have multiple owners. If Tom, Dick, and Harriet are equal partners the business has to generate about $1 million in profits to get them into the higher bracket, and if they each go $10,000 over it will cost them an extra $460 each.

    So the notion that this is some sort of major blow to small business is nonsense.

    • Quincy Adams says

      You are right that I should have emphasized the high threshold.

      And you are also right theoretically on the impact of risk, though it is hard to see that changes to the marginal rate in the range we are talking about would have a significant effect on a rational calculation. But as far as risk is concerned, the major element of risk in deciding to hire additional workers revolves around the question of future demand. The deleterious effect on the economy and the increased uncertainty of the Republican Congress holding the economy hostage in the debt ceiling renewal and now in the fiscal cliff negotiations have a much greater impact on the risk side of the risk/reward calculation in the context of a fragile recovery than the marginal tax rate has on the reward side.

      • Byomtov says

        …it is hard to see that changes to the marginal rate in the range we are talking about would have a significant effect on a rational calculation. But as far as risk is concerned, the major element of risk in deciding to hire additional workers revolves around the question of future demand. The deleterious effect on the economy and the increased uncertainty of the Republican Congress holding the economy hostage in the debt ceiling renewal and now in the fiscal cliff negotiations have a much greater impact on the risk side of the risk/reward calculation in the context of a fragile recovery than the marginal tax rate has on the reward side.

        I agree, and yes, my point is pretty minor.

        In any case, the “Oy, small business!!” argument against the rate increase is largely nonsense, as it was against the estate tax.

  2. says

    The argument works in a plantation economy. Supervising slaves is disagreable work and the workload (flogging, etc.) increases roughly in proportion to their number. For a large plantation, the owner hires overseers to do the flogging, but they have to be supervised too, and it´s no fun either because the overseers are thugs. It´s plausible that Simon Legree will respond to a higher marginal income tax rate by selling slaves and drinking more.

    In a modern economy, it´s far more likely that having more subordinates raises your self-esteem and status, in every size of enterprise, and not your workload because you can delegate. I was a rather poor middle manager (but a much better analyst and draftsman) because I dislike ordering people around, but I reckon I´m atypical.

    • J. Michael Neal says

      Delegating authority is a lot more difficult than people tend to assume. That’s even more true of the type of people who are entrepreneurs than of the rest of us. There’s a lot of data suggesting that the skill set needed to start a business and get it going is rather different from the skill set needed to grow that business past a point that arrives more quickly than it is often assumed.

    • Quincy Adams says

      I haven’t been deep into this literature in a long time but what Ruth Marcus says is along the lines of what I remember all the way back to the early 1980′s… Yes small businesses are the the scene of a lot of new hiring but also lots of job churn and they fail at very high rates also — think restaurants. A few small businesses create the bulk (or in some periods maybe even more than the total) of the net new jobs that small businesses create, and they do so only by becoming big businesses. There is also the problem that lots of things that we don’t ordinarily think of as small businesses fit in this category for the purposes of the tax code. So Mitt Romney referred to his time at Bain Capital as having founded and run a “small business.” Franchises (such as fast food stores) are also often small businesses, as are sole practitioners who don’t have much job dynamism. Certainly public policy is in danger of being distorted by “the myth of small business” as a meaningful, undifferentiated, or particularly virtuous sector of the economy.

  3. Byomtov says

    In a modern economy, it´s far more likely that having more subordinates raises your self-esteem and status, in every size of enterprise, and not your workload because you can delegate. I was a rather poor middle manager (but a much better analyst and draftsman) because I dislike ordering people around, but I reckon I´m atypical.

    I think this is sometimes true of managers in large organizations, but not so much of small business owners, who do tend to be more pragmatic about such things.

    And you’re not atypical, either. Management is only enjoyable when your managees know more than you do, so your only job is to let them do what they want.

    • says

      As you expand your business you are often hiring people who know more than you do about aspects of it, or like doing things you don´t: a bookkeeper, a receptionist, an IT person. This makes for a more agreeable working day than doing it all yourself. My point was that managing more people has to be a disutility for the Boehner talking point to work, and it doesn´t.

      I´m having second thoughts about Simon Legree. A sadist would like having more slaves to flog. However, I feel that would be atypical of slaveowners.

      • Barry says

        “I´m having second thoughts about Simon Legree. A sadist would like having more slaves to flog. However, I feel that would be atypical of slaveowners.”

        Probably not; sadism would be a plus.

        [pedantry alert- yes, too much sadism is counterproductive, but so is humanity, when it comes time to make slave work really really hard under unpleasant conditions, for a slave-level subsistence existance]

  4. Anniecat says

    Has anyone else around this board done any work in a small business? I’d like to know if my experiences on this topic were outliers.

    I’ve worked in several small businesses over nearly 40 years in the work force. These businesses were small enough that I was often involved in hiring decisions. None of the business owners — not one — ever considered the tax impact when deciding whether or not to hire a new employee. The only consideration was whether we were physically able to get the work done with the staff we had. If we could, we didn’t hire anyone new. If we couldn’t — if the staff on board could not produce the work on time — we hired somebody. There was always a good deal of discussion of whether a new hire should be part time or full time, what the basic salary would be, and whether we should hire somebody with more experience who would cost more money but use up less training time, versus less experience/more training. But that was the only discussion of cost of hiring, ever.

    All of these places were either sole proprietorships or partnerships, which means the entire income of the business was treated as the personal income of the owners, so the tax bite sank into their hides. All of these owners were also very aware of taxation and took all legal means to minimize their tax payments. (An example: I once spent a total of two full working days doing nothing — nothing — except telexes to a European company, trying to get them to waive the value-added tax on something my boss had ordered from them. The VAT was a lot less than the cost of my wages over that time; I’ll leave it at that.)

    Is my experience unusual? Or are Boehner and his fellow Republicans just blowing smoke about taxation? (Or both.)

    • Quincy Adams says

      My understanding is that the bulk of the academic research agrees that the main determinant of hiring and layoffs is current mismatches between demand and capacity. You can get owners to mention taxes in a survey because they are being strategic in their answers or because they are parroting the Republican line, but that’s about it. The studies that look at increases in State minimum wage laws (serving as natural experiments), that conservative economists always argue should suppress demand for labor and which would should show a much more direct effect on hiring than taxes, generally fail to find much of a negative effect on employment, if any. Small businesses have limited training and recruitment capacities and so the lack of availability of people locally with the right skills and certifications also can be a significant constraint to hiring.

    • Byomtov says

      Your experience matches mine, anyway. In many years in small business I don’t recall a hiring decision ever being influenced by tax rates. It’s generally been either, “We really need to add someone to do X,” or, occasionally, “This individual who just showed up looking for a job seems awfully valuable. Let’s hire him and worry about the details later.”

      The latter, of course, only happened when we could afford it, but it did happen. I suppose it’s in line with Quincy’s point about availability of people being a constraint.

    • Freeman says

      Having spent 18 years at four companies with less than 20 employees, I can vouch for your experiences. As the former co-owner of one of those companies I can tell you that keeping up with demand is the ONLY reason we hired new help. Tax considerations only entered the picture when determining how we would pay ourselves. There are five of us at my current gig; we’re interviewing for a sixth because we’re all working lots of overtime keeping up with demand, and we need the help.

    • Dave says

      The income of the business was treated as personal income because that’s the way the owners of the business decided to treat it. If there were no tax advantages for doing it that way, they could easily restructure as a c-corp for a more normal tax treatment.

    • Ken says

      I also can confirm your experience with my own. 12+ years working in a firm that employed 15-20 people. The only factor that drove hiring decisions was the anticipated work load. The Republican talking point on this topic is pure, unadulterated BS.

  5. says

    Y’all are working with the wrong definition of “small business”. Bain Capital is a small business. Every boutique hedge fund is a small business. Every white-shoe law firm with fewer than 500 total employees is a small business. And those people almost certainly consider the tax implications before hiring someone.

    • CJColucci says

      I’d be astounded if large white-shoe law firms — I worked with one and know mant others — considered the tax implications of hiring associates. I have seen them consider how much business they have or anticipate. What are those “tax implications,” by the way?

  6. Altoid says

    The line Boehner was flapping his jaws about is BS and has always been BS, born of country-club and lunchtime and in-flight conversations among big-money republican types and other professionals who always gripe about taxes because that’s what they do, and midwifed by Frank Luntzian focus groups to refine a tag line that would impress the rubes. There never has been anything to it. It’s unfortunate that media people are so easily impressed that they’ll dutifully repeat this laughable idea as if it had any validity, forcing Quincy and others like him to debunk it comprehensively. I really don’t think the rest of the political/media world accepts just how completely cynical and post-modern the gop is these days. They have completely dissolved all connection between what they talk about and what is. They speak only for effect, and as the party completely of PR, Frank Luntz is their high priest.