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.