November 21, 2014

The Politics and Economics of Taxing Small Business Owners

President Obama wants to raise taxes on households making more than $250,000 per year by letting President Bush’s tax cuts on upper income earners expire. Mitt Romney opposes this move, saying that raising taxes on the wealthy would hurt job creation.

tax squeeze

Because both candidates want to appeal to small business owners, each is careful to argue that his approach is better for them.

The president is focused on how many small business owners will be affected by his tax increase, which is relatively few. The Office of Tax Analysis at the U.S. Treasury crunched the numbers for 2007, the most recent year that data are available, and reported that only 4 percent of small business owners would be subject to a tax increase if the Bush tax cuts expired.

But the Republicans aren’t arguing that raising taxes on households earning more than $250,000 will adversely affect a lot of small business owners. They know the performance of small businesses is skewed, with a few companies accounting for most small business profits.

They claim that raising taxes on households earning over $250,000 a year will adversely affect a lot of employment. The small number of highly profitable small businesses, they claim, account for most of the hiring done by small companies. Therefore, letting the Bush tax cuts expire will mean higher taxes on the people who provide jobs to a lot of Americans.

Finding an estimate from a reputable source on the fraction of employment provided by those small business owners isn’t easy. Most data on small business income isn’t linked to data on small business employment. But the Federal Reserve Survey of Consumer Finances (SCF), a representative sample of a cross section of American households, does.

George Haynes of Montana State University, who has conducted much research on small business using the SCF, took a look at the employment of small business owning households for me. In the 2007 SCF, his analysis showed that small business owning families earning more than $250,000 per year employ 93 percent of the people working in small businesses.

The message from these different data sources is clear: Letting the Bush tax cuts on households earning more than $250,000 per year won’t affect very many small business owners – just the ones who employ the vast majority of people working in small companies.

Tax Photo via Shutterstock

25 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

25 Reactions

  1. Good day:

    It is nice to see this issue being discussed.

    What caught my eye was the following finding:

    “In the 2007 SCF, his analysis showed that small business owning families earning more than $250,000 per year employ 93 percent of the people working in small businesses.”

    While many see President Obama’s vision of everyone paying their fair share as redistribution of wealth, this is not some fantasy of Robin Hood stealing from the rich to give to the poor.

    This is President Obama, and those who share his view, taking from those who have earned it (and need it for their families and their employees) and giving it to the government whose fraud, waste, and abuse is already known.

    Thank you.

    Thank you.

    • I am a small business that has earned more that $250K per year for the last 15 years. I’ve paid very little because most of that $250K wasn’t taxable because only profits are taxable.

      Raising taxes on those with profits over 250K won’t affect 93% of businesses because most of them don’t earn that much in profits.

      Only a small fraction of businesses have profits over $250K per year.

      Even then, only those profits over $250K would be taxed at the higher rate, not the first $250K.

      • DougH2, It still penalizes a business for profits over $250K.

        Also, I don’t quite understand what you mean. Gross revenue (sales) are not at issue here because generally sales don’t have tax implications. Taxable earnings (profits) are at issue. For LLCs and sole proprietorships in particular, earnings are precious and relate directly to that business owner’s personal bottom line. So a business owner trying to save for his kids’ college educations, and trying to afford a better lifestyle for her family after having sacrificed for years, and perhaps squirrel away some capital in order to keep expensive line of credit borrowing down or simply to sleep easier at night, is going to find that harder to do — and at the same time find the money to hire more people AND invest in the business.

        The more government wants a bigger cut of the pie, the less there is to go around for all those other things.

  2. May I ask for clarification? My understanding is that wages are a tax deductible expense to business, so the tax raise in question would only hit business profits after wages have already been paid. Unless your argument is one that the tax ultimately attacks incentives, I don’t understand how this affects the employment picture.
    Thanks.

    • ChacoKevy,

      If there is less profit to go around, there’s less money for future hiring (and possibly it may mean layoffs). Small businesses only have so much money to go around. If it goes to the government to be redistributed to everyone else, there’s less available to the business for hiring, investing in new equipment, etc.

      Small businesses are not like huge corporations (or the government) where there are big reserves and as we used to say when I was in the corporate world “dark hiding places” the CFO always seemed to have of extra cash to draw on or big lines of credit that can be fired up. Nor do you have the economies of scale like a corporation where you can go to hundreds of departments and say “each of you cut 5%”, and suddenly you have saved millions simply by cutting out travel, subscriptions and some new office furniture. The small business owner has much less cushion to deal with, and looks at his or her bank account and says “Do I have the money to hire another person?” That’s how personal it gets in a small business.

      – Anita

      • Hi Anita,
        Thank you for your response. I’ll say upfront that I don’t disagree with the larger point in general, but I’d like to contest a few ideas though. Hiring decisions aren’t necessarily driven by how much cash is on hand after profits. Hiring decisions should be made because of the productive capacity created by hiring; by the business needs. I don’t hire additional sales staff because I want to, I hire them because they will generate value in excess of the wages paid. A return on investment.
        Conversely, let’s say my small business is me being super bad-ass at karaoke. If I were to become an overnight sensation, with my face on posters hanging on your kids’ walls, it doesn’t necessarily mean I MUST hire a marketing department, agent and concierge services because I now have all these profits laying around. When you bring profits into hiring practices, you are hiring for luxury, not business need.
        Secondly, I think it needs reiteration that the tax is only on incomes above $250,000. It isn’t a full return to Clinton level taxes. So if profits are 300k, it is an increase of the tax burden of $2300. My apologies, but I’m not convinced that this is the difference between hiring/laying off.
        Finally, my misunderstanding is a little more macro oriented. The CBO is projecting this year’s tax revenue to be 14.8% of GDP. Historic lows. Yes, small businesses don’t reap the same tax preference that large corps do, but SMB’s should have seen the benefits nonetheless in increased demand and subsequent revenue.
        In the end, I suspect we believe the same thing. Tax reform, a major overhaul (I’d prefer progressive consumption tax, but will settle for lower rates on eliminated loopholes) is really what is needed. But a 4.6% increase on incomes over 250k? I still need convincing.
        Thanks,
        CK

      • ChacoKevy, when everyone who earns income pays taxes — do you realize how many people dot pay taxes including President Obama’s favorites? — then we can get into that a small difference doesn’t matter.

        However, when you have government going after more and more money to go more and more in debt, build a larger government, refusing to enforce laws on the books, going after state governments that want to have fair voting by removing dead people and illegals from the books…

        As the steward of a small business, that $2,300 you mention matters.

        It may not make or break hiring decisions, but it does matter.

        Unlike the government, I don’t print money when I need more money.

      • Hiring employees and buying equipment is tax deductible. My point is a business can hire employees and buy all the business equipment needed before having to worry about what the tax liability is going to be.

      • Magicbean, taxes do matter. At the end of the day, what’s left over is going to get taxed. If there’s less left for the business owner because of the tax man, well, that’s less that business owner has for his or her own use. And less he or she is going to consider available for taking more risk.

        Understand a business owner’s mindset. That business owner may have sacrificed for 5 or 10 years before the business eventually started taking off. He or she may be wanting to finally reap some benefits after forcing his family to eat mac and cheese 3 times a week for years while plowing every cent back into the business to grow it. If the tax man is going grab a larger chunk, why would he or she want to work harder? What’s the point of sacrificing to build a business, if your profits are going to be redistributed to the rest of the population — who didn’t take the risks and didn’t make the sacrifices, under a government that shows zero fiscal responsibility? The business owner sees little point in taking a risk to saddle the business with another expenditure (another employee) that won’t be easy to cut back on if something negative happens, if there’s no upside.

        Taxes take away the incentive to take risk and sacrifice to grow a business.

      • What you’re missing is just because an S-corp or LLC make 300K in profit doesn’t mean they take home 300K. Many small business owners take a paycheck and live off of that income. Therefore the 300K stays in the business for growth. If you take away that 2,300, there is less money for growth. Maybe hiring is not impacted by 2,300, but raises sure could be, expanding the business to include an additional vendor, if you’re in retail. You may not be able to afford that extra inventory. Also 250K business may be in that 40-50 employee range, that Obama care mentions. If I were that small, I would think twice about expanding my business beyond 49 employees. You may not believe these topics feed the decision making process, but you have no leg to stand on until you are that small business executive making the decisions. That goes for the stiffs in Washington as well.

  3. Hi ChacoKevy:

    I’m not a tax account; but I’m the steward of a small business.

    My understanding is the answer to your question depends on the business structure — sole proprietorship, partnership, limited liability corporation (llc), or corporation (of which it could be an S corp or a C corp).

    C corp’s has payroll deductions as an operation expense.

    S corp, sole proprietorship, and partnership (not sure about LLC) as far as I know funnel everything through the individuals involved, so their tax base can be higher when the business is making a profit (which is generally the goal of all for profit businesses).

    Thank you.

  4. Great analysis Scott. This is a perfect example of politicians using sound bites to sway voters while ignoring the numbers behind them.

  5. Is this a form of taxation without representation? When will business owners say: “enough is enough”?

  6. Government rarely spends wisely. The stories about $100 wrenches and parts the government buys that are really $10 or less are not just stories, but reality.

    Small government that spends frugally is better for small businesses than ram it down your throat President Obama mentality.

  7. As a business owner I could not agree with Anita more. She has laid out the facts as to how a business owner looks at their business. And to correct a prior poster saying that you don’t hire people based off of funding…. To back up Anita again, small business does not have the resources that a large corporation has so we don’t go out and borrow money to hire…. If your business is not profitable you scale cost down to regain profitability and once profitability is realized in cash flow then you look at reinvesting in people to continue to drive revenue.

    Both me and my business partner have put our foot on the brakes until we feel like there is stability and that we are not going to come under attack from the government on taxes. Once again to back up Anita…. Ask yourself this question. If you are already profitable in your given moment why would one add risk/cost to your business only to pay a higher rate in taxes….. Then ones response to me would be, we’ll only the profit over 250k would be taxed at the higher rate. The answer to that is in a prior statement I made…. You are already a successful business so your making over 250k so any additional profit by reinvesting is taxed to the MAX. Pending the election results we will either be hiring 5 new employees from the community immediately, building a brand new building at a new location, purchasing several pieces of new capital equipment OR do absolutely nothing and be completely satisfied with our current profits and looks for ways to become more efficient at what we currently do.

  8. As the owner of a successful small business, I may be affected by these increased taxes. While there are many arguments about how big the government should be, it’s plainly false to suggest that these taxes will have any impact on rationale decisions for the referenced “small businesses” in this article. Please see this page for a great analysis:
    http://freemarketsgoodbeer.blogspot.com/2011/01/tax-rates-affect-hiring-decisions.html

    • Chris, thanks for that analysis. One thing: that article assumes every business owner evaluates the decision to hire the way the article outlines. They don’t.

      – Anita

      • Just like you’re assuming every business owner built their company from the ground up, sacrificed sweat, blood, and tears, and fed their family mac n cheese until things got going?

        If tax rates were the sole basis for business building and income earning, we’d be seeing a much lower labor participation rate. If you are the owner of a business that qualifies as “small” and are actually recording profits subject to the highest marginal tax rate, then I think we can reasonably infer that there exists a budgeting structure that can account for a negligible 4.6% tax increase. Not to mention your analysis of the tax man wanting a larger share of the pie means less for the company (you are assuming we are working inside of a closed economy – spoiler: WE AREN’T).

        Furthermore, how many “small businesses” are actually recording those kinds of profits Anita, those subject to the highest marginal rate? You think 4.6% will kill the American dream? You think businesses are just going to pack up shop and say “Hey, we had a good run while it lasted at 35%.” If you’re a successful business owner, you know how to adjust for tax fluctuations. 4.6% will not kill jobs, you will not see massive layoffs, rather, you will see business strategies adjust, probably towards more risk-aversion (WHICH ISN’T A BAD THING). Stop acting like this is the bane to all future business development.

      • MrPenguins, taxes are not the “sole” issue. It’s more like the straw that breaks the camel’s back.

        As to how many business owners are impacted by tax rates, well — it depends on the point of the lifecycle your business is in. Most small businesses go for years with fairly small profits (and large sacrifices) until such point as the business “makes” it or gets sold. But you see, that’s why they sacrificed in the first place — to get to that point. High taxes diminish the incentive to sacrifice.

        Until you’ve walked in the business owners’ shoes, don’t purport to tell them how happy they should be to have their money taken away. You can make all the arguments you want but you’re unlikely to convince business owners.

  9. Anita’s analysis is right on. But let’s be frank, even if Obama’s policies have zero impact on small business (even though we all know they do), it’s the small business owner’s perception of the impact that matters. If the owners thinks they are being affected, they will act cautiously, no matter how well the pundits spin that the tax hike won’t hurt them. If they think they’re getting squeezed, they will act accordingly.

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