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
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.