President Obama’s tax proposal would allow the Bush tax cuts to expire on “the rich” (singles making more than $200,000 and couples making more than $250,000). The top federal income tax rates for these payers would rise from 35% to 39.6%. “But you can’t do that!” scream the Republicans, “You’ll hurt the job creators!” “No, we won’t!” cry the Democrats.
So who are these “job creators?” Is it valid to claim that increasing the top rate will hurt small business and the economy? As with most things political, the truth lies somewhere between the two rhetorical extremes.
To understand the “job creator” issue, you need to know the term “flow-through business.” A flow-through business is one in which the business’s profits flow through to the owners’ tax returns and are taxed the same as wages. Nearly any sole proprietor, partnership, limited liability company, or S-corporation is a flow-through business.
To illustrate what the Republicans are talking about, meet the fictional couple Henry and Lucy Lee, who quit their jobs three years ago and started “Lee & Lee Guitars”, a guitar manufacturing company. They’ve built up a nice little business, employing twenty people. Henry runs the factory and Lucy does the marketing. They aren’t rich, but they’re comfortable on the $100,000 salaries they pay themselves, and the company breaks even or has a small profit most years.
Then one day a major music star reveals she plays a Lee & Lee guitar. Suddenly, everyone wants a Lee & Lee guitar. The Lees and their employees work day and night to meet the new demand.
When the year ends, the Lees are astounded to find the company made a profit of three million dollars! They have big plans for that money – they’re going to invest it back in the business, build a new factory on the east coast, double the number of employees, and open retail stores in Austin, Los Angeles, New York, and Miami. Three million dollars should be just enough to complete the planned growth!
“Not so fast,” says the accountant. “You have to pay 39.6% of that money in federal income tax.” The Lees protest, “But we only made $200,000 in wages! Obama says we’re not even rich!”
The problem is that the Lees own a flow-through business, so even though they only took home their salaries, the profits of the company flow through to their personal tax returns and they have to pay taxes on it. So, greatly simplifying things for the sake of illustration, their taxable income is $3,200,000 and their federal income tax bill is a hefty $1,267,200! Obviously, in order to pay the taxes, they have to take the money out of the business and now there is only a little more than $1.7 million to cover the planned growth, so they have to hire fewer people, open fewer stores, and maybe build a smaller factory.
Admittedly, this is a contrived example and even under the current tax rates, the Lees would have to pay $1,120,000 in taxes. This is still, however, $147,000 less than the under the Obama proposal. That difference might be enough to pay the annual salaries and benefits of two or three extra employees, depending on the job and the area of the country.
But how many businesses are like the Lees, and would end up paying more under Obama’s proposal? The Obama campaign points out that 97% of small business owners make less than $250,000 and would thus be unaffected. That may be true, but that figure includes everyone who claims business income on their federal income taxes, even if the amount is negligible. A more important fact may be that, according to the accounting firm Ernst & Young, 54% of the private work force is employed by flow-through businesses.
Certainly not all flow-through businesses are in a fast-growth stage like the Lees, and some of these businesses are large companies with very wealthy owners. For example, Goldman Sachs was a flow-through business before 1999. If a company is not growing and not hiring new workers, then increasing the tax rate obviously won’t cause it to hire fewer new workers. On the other hand, some economic studies have concluded that raising the top federal income tax rate will have a significant impact on the growth of small businesses and the hiring that goes along with it.
The issue of allowing the Bush tax cuts to expire for earners making more than $250,000/year is not as straightforward as either side would like you to believe. The unfortunate thing is that neither side seems to want to explain the issue in an understandable way.
By Brian Bell, Director of research at the Bornhoft Group
The Bornhoft Group, founded in 1985, is an alternative investment manager, primarily serving institutional clients.
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