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Small Businesses and the Income Tax

My latest piece for the print edition is on small business and credit.  Shorter:  though you hear a lot about credit, it's far from the main problem facing businesses now.  We're witnessing one of the periodic sifting-outs, where the process of creative destruction crushes a lot of small business owners.

As always, I had a great deal of material I didn't use, and some of it is germane to the debate we've been having over the income tax.  Does raising the top brackets affect how small business owners behave?  And should we care?

As it happens, I'm somewhere in between Democrats and Republicans on this.  On the one hand, Democrats and some of their ideological fellow-travelers have been pushing the line that only 3% of taxpaying "units" are in the top two income tax categories, which is technically true but misleading--it is true only because Peter and I, with our freelance income, and my college friend with her sideline selling crocheted things on Etsy, and millions of other people who earn a little bit on the side, count as "businesses" under this definition.  In fact, around half of all small business income is earned by people in the top two brackets.

On the other hand, Republicans, too, have been exaggerating:  exaggerating the extent to which the average small business creates jobs (job growth is mostly concentrated in a handful of fast-growing ones that don't stay small), for example.  And regardless of their job creation potential, small business owners are not some master race whose every whim must be catered to; we cannot simply make tax policy around what is, or isn't good, for small business.

So I end up thinking that it will effect small business, that I'm very sorry about that, but that we need to go ahead and raise the taxes anyway.  I feel the same about taxes on the middle class.

That leaves us with an empirical question:  what effect will it have?  Conservatives seem to be predicting an apocalypse, while liberals roll their eyes and profess to believe there will be no measurable effect at all.  Once again, I'm somewhere in between.

Small business owners have a bunch of fixed costs, like their mortgages, their kids' schools, etc.  I'm not arguing whether they deserve to live in a big house, or send their kids to Catholic school, or drive a lovely car.  I'm only arguing that they often do those things, and over the last ten years, they have undertaken fixed obligations based around their after-tax disposable income.  For your typical small business owner, that after-tax disposable income is the corporate profits, less their personal income taxes, minus any investment they want to do (which is not necessarily immediately tax deductible).  Small businesses tend to be structured as pass-through corporations, with the income taxed at ordinary income rates.

So what does it mean if their taxes go up?  If you reduce their after tax income, you may have a negative effect in one of two ways.  First of all, you reduce the future return on investments they make now.  If they sacrifice a given amount of after-tax income now, they end up with less after-tax income in the future.  On the margin, some people will probably decide to use that money for current consumption rather than investment.

The other way you may lower investment or job creation is simply that you leave less money on the table to be invested.  Owners who have fixed expenses that they cannot easily reduce will take the money out of the business now, even if it potentially costs them later.

Will this marginal effect bring America to its knees?  Hardly.  But will it deter productivity and employment enhancing investment?  Almost certainly.

That said, we need money to cover promises we shouldn't have made decades ago.  The current structure of our federal budget isn't sustainable, which means we'll all have to learn to get by on a little less--including small business owners, and the people they employ.