The Tax Man Cometh

Obama's tax plan will hurt small businesses and damage the economy.

Congress may be home campaigning for the upcoming election, but the tax policy debate has not cooled down. Whether in a lame duck session or as a first order of business come January, something will be done to address the coming tax hike triggered by the expiration of the Bush tax cuts.

The debate is focused largely on whether or not to raise taxes on the rich in order to chip away at the deficit. But there is a lot of confusion as to how exactly increased taxes on the top 2 percent of wage earners would impact small businesses and economic growth.

President Barack Obama is chief among those confused. He appears to be concerned with the health of small businesses in America, but at the same time is proposing policies that will hurt businesses large and small.

In a Labor Day speech in Milwaukee, the president suggested that helping small businesses is vital to economic recovery and proposed a permanent extension of the research and development credit established by the Bush administration. He also argued for letting businesses write down 100 percent of their capital investments over a one-year time frame, instead of the current three to 20-year process.

However, at the same time Obama also proposed allowing income tax rates on those making more than $250,000 to go up, which will hit small business profits, since those profits are often filed as individual income. Obama also defended letting rates go up for wealthy taxpayers on investment profits, including capital gains and dividends.

This policy stems from the administration’s attempt to manipulate capital towards what it sees as productive ends. On the one hand, the administration would like more federal revenue spent on the stimulus without adding to the deficit. On the other hand, White House economists want more investments in the economy to boost productivity and with it employment and exports.

These contradictory policy goals will only blend if stimulus spending actually helps the private sector grow. However, they both face an uphill battle.

Politically speaking, increasing taxes for the wealthier segments of society is popular, even though the wealthiest 10 percent already pay 70 percent of federal taxes. But what is often misunderstood is that small business owners will take a substantial hit from these taxes. Many small businesses make more than $250,000 a year-though they don’t earn enough for it to make financial sense to file their taxes in the corporate bracket.

Your local dry cleaner or grocer likely brings in more than $250,000, but then has to pay their few employees from those earnings, leaving the owners with take home pay far below the rich man’s threshold. It is these employers and entrepreneurs that would be hit hard by a rate increase on the top two tax brackets.

The Tax Foundation has recently estimated that-assuming business income is the last dollar of income a taxpayer earns-39 percent of the proposed $629 billion tax increase on high-income taxpayers would be extracted from business income. This policy path is completely at odds with the administration’s attempts to boost small business spending. Of course, that policy path has additional flaws of its own.

It is understandable that the administration wants to see a boost in business investment for new plant equipment, vehicles, computers, and other capital purchases. Unemployment has remained high and the uncertainty holding the economy hostage has sidelined some $2 trillion in retained earnings, according to The Wall Street Journal.
Maintaining the research and development (R&D) tax credit will avoid having current investments pulled out of the economy and creating losses in the near-term (though the private sector would pick up the slack in the long-term). And the ability to write down capital quickly could prove a substantial incentive for investment. Increased business spending would also be good for jobs and productivity.

However, even if the tax cuts work as planned, they won’t be enough to lead the economy out of recovery. While the R&D credit would be permanent, the investment credit would only be for one year. This means the short-term investment in 2011 will be partially stolen from 2012 and 2013 just as we’ve seen with the aftermath of 2009’s Cash for Clunkers program. In fact, if the credit was too effective, it might cause a significant decline in GDP for 2012 and beyond, a prologue of which we are watching now in the housing market in the wake of the First-Time Homebuyer Credit’s negative impact on sales and home prices.

An even worse scenario for the administration would be if the small business tax cut did not inspire any new investment to come off the bench. Many small businesses already write off up to $250,000 on equipment and other capital investments. So small businesses would have to significantly increase what they spend to see a tax benefit. Yet tax advisor Maureen McGetrick says that businesses like small retail stores and consulting firms don’t need to spend more than $250,000 in any given year. “You don’t see a lot of small businesses making that type of investment,” she told the Journal.

Further still, businesses are only likely to invest once their debt has been brought down significantly, and when they see a near-term benefit for the investment. Just because a fisherman could invest in upgrades to his boat doesn’t mean he has the demand for the additional lobsters or cod he might pull in.

On the stimulus side, all the evidence of the past two years-and historical evidence from examples like Japan-shows that dumping cash into runways and railroads is unlikely to create sustainable economic growth. And even if the spending does create a positive spark, the current proposed $50 billion in infrastructure spending will have a diluted effect in the near-term since the American Recovery and Reinvestment Act’s stimulus spending isn’t even complete yet.

The true danger is that the increased taxes required to pay for this stimulus (and the previous additions to the deficit) won’t be a net benefit to the economy. The top 3 percent of the economy consumes one fourth of purchased goods in America. Those top three are also big savers, which is necessary for investment to flourish in a post-cheap money world.

One of the presuppositions of the Obama plan is that since savings don’t help the economy, it would be better to tax the rich (who are savers), and give that money to spenders to stimulate the economy. But on the contrary, without savings-cash put in the bank-far less capital would be available to borrow for productive private sector investments. “If you don’t put money in the local bank,” says William C. Dunkelberg, chief economist at the National Federation of Independent Business, “we can’t finance any of these investment expenditures. It’s that simple.” The U.S. has a dismal savings rate as it is.

Increasing the top marginal tax rates to generate $650 billion to $900 billion in federal revenues over the next 10 years means that the same amount of money won’t be invested in the economy as consumption or savings. If the government can find a way to get a better return with that cash than the private sector, however, then the White House may be able to make a strong argument for the tax cut in retrospect. Historical data suggests this won’t be the case.

The near-term goal for the administration should be fighting uncertainty. Nervousness about future tax increases-either in 2011 or beyond-has frozen many businesses in their tracks. Regulatory concerns are keeping the banking industry holding tightly to its cash. And the administration’s failed attempts to deal with housing and unemployment have consumers less than enthused about dialing up their credit lines again. A confusing tax proposal that has contradictory ends isn’t the best way to bring certainty to this market.

Anthony Randazzo is director of economic research at Reason Foundation. This column first appeared at