As the Gang of Twelve begins its deliberations, the topic of tax rates on the richest is sure to make another appearance. The Right will claim that these are the people who run small businesses and create jobs. Here is Mitt Romney doing just that:
Look, I know there are some who say "let’s just tax the rich." Let’s raise the taxes on the rich…Businesses, small businesses. Are you a sub-S corporation or a c-corp? For those that aren’t familiar with that, that means that his business pays personal income tax. He’s taxes at the personal income tax rate.So if we raise taxes on wealthy people, that means businesses see their taxes go up. I don’t want to raise taxes on employers.
The left has offered two responses to this claim, but there is a third (and stronger) answer.
The first answer is that, "Fewer than 2 percent of small businesses owners make more than $250,000, never mind the $1 million level, at which Buffett is advocating a tax increase." Paul Krugman also weighed in, noting that the "small business income" included that of authors, "partners in medical groups and law firms, much of the income of hedge fund managers, and so on." The trouble is that nobody expects dinky little small businesses (or even hedge fund managers) to be engines of job creation – surely it’s the successful real businesses, the ones making seven figures or more, that have the best chance.
The second answer came from Jared Bernstein, who noted that historically, high tax rates for the rich have been correlated with high GDP growth. There is no case in our history that high taxes have restricted growth – the opposite, if anything. I can add to his report the fact that the correlation is even stronger if the tax rate is matched against GDP growth one or two years later, but neither of us can claim that there is a cause-effect relationship. All you can say for sure is that high rates have not led to bad economic consequences. It’s a pretty good response, but not decisive.
The Third Answer
There is a third answer: all we must do is notice that even a traditional small business – a Widget maker, let’s say – is if anything more encouraged to create jobs by higher tax rates than by low ones.
Consider Mr. Morebux. He’s married with no kids and is the sole proprietor of Morebux Widgets, a highly successful enterprise. Last year MW had profits of two million dollars, which were all taxed as personal income to Mr. Morebux. This is a totally theoretical case, so I’ll assume that Morebux had no other income and no deductions other than the standard for a married couple. (They do pre-pay their state and federal taxes, to avoid penalties. Pre-paying state tax results in a deduction.) Morebux pays $668,548 in federal taxes (including Self Employment taxes for social security and medicare). He pays $155,194 in state income tax as a resident of North Carolina; his after-tax income is $1,176,258.
Mr. Morebux will certainly hire new workers and expand his business, if the market is there. If it costs $100,000 (including all those nasty regulations and taxes) to employ a worker for a year and the worker can be expected to add $110,000 in revenue, it’s a good deal. Mr Morebux will pay tax on the $10,000 extra profit, but he is ahead on the hire. This decision does not depend at all on his tax rate, as long as he gets to keep any of the extra profit. Actually, he will keep more than half. Does uncertainty about his future tax rate matter? Not as long as the jobs he creates make a profit for his business. It would be irrational for Mr. Morebux to say, "My tax rate may go up. With less net income I can’t afford that extra profit."
So the logic of the situation requires us to consider whether Mr. Morebux will hire workers who do not directly generate profit. Suppose he is considering hiring an EMT. He could hire an EMT for $100,000 a year, and there would be no additional revenue from this hire. (Excuse me. An EMT in this case is an Executive Massage Therapist. Mr. Morebux already has a Personal Assistant.) If he does employ the EMT, the net cost to him (after tax) will be $54,916, not the $100,000 his business actually pays. This is a pretty good deal, but it would be an even better deal if the tax rate on high earners were higher. If the state and federal taxes were raised to confiscate ninety cents on the dollar (for income greater than a million, let’s say) then the EMT would only cost $10,000 a year after tax – a true bargain, not available to a wealthy person who does not have his own small business.
The case above is not as unrealistic as it seems. Mr. Romney and the others who cast taxes on sole proprietorships as “taking money from small businesses” surely know this. A small business owner is taxed on what he takes from his business, not on what he puts into it. And that is the third answer.