New Ernst & Young Study on Top Rates

Today, the S Corporation Association released a new study by Ernst & Young focused on the rate debate in Congress and its impact on job creation and business investment.

According to the study, allowing the top rates on individual, business, and investment income to rise starting next year would, over time, result in fewer jobs, lower wages, and less investment.B Key documents include:

Authored by Dr. Robert Carroll and Gerald Prante of Ernst & Young, the study examines the economic impact of the higher tax rates at the heart of the rate debate in Washington right now:

  • The top two rates on individual and flow-through income;
  • Tax rates on capital gains, dividend, and interest income earned by taxpayers making more than $250,000;
  • The reinstatement of the phase-out of itemized deductions (Pease); and
  • The addition of the new 3.8 percent tax on investment income.

The study points out that this policy would raise the top tax rate on S corporation and other flow-through income from 35 percent to nearly 45 percent.B As a result, the marginal effective tax rate on new business investment would be more than 15 percent higher than it is today, discouraging businesses from investing in new plant and equipment and resulting, overtime, in fewer jobs and lower wages.B As the study concludes:

Through lower after-tax rewards to work, the higher tax rates on wages reduce work effort and labor force participation. The higher tax rates on capital gains and dividend increase the cost of equity capital, which discourages savings and reduces investment. Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.

  • Output in the long-run would fall by 1.3%, or $200 billion, in todaybs economy.
  • Employment in the long-run would fall by 0.5% or, roughly 710,000 fewer jobs, in todaybs economy.
  • Capital stock and investment in the long-run would fall by 1.4% and 2.4%, respectively.
  • Real after-tax wages would fall by 1.8%, reflecting a decline in workersb living standards relative to what would have occurred otherwise.

These results suggest real long-run economic consequences for allowing the top two ordinary tax rates and investment tax rates to rise in 2013. This policy path can be expected to reduce long-run output, investment and net worth.

For the past year, the S Corporation Association has partnered with NFIB, the US Chamber, and other business groups to highlight the challenge the pending Fiscal Cliff poses for pass-through businesses and their employees.B This study builds on the 2011 Ernst & Young study which found that pass-through businesses are the majority employer in the United States, providing 54 percent of private sector employment.

Larger pass-through businesses contributed significantly to this employment level, employing approximately one out of six private sector workers.B Meanwhile, a recent CRS report found that the five industries most affected by raising taxes on large S corporations (those with more than $10 million in revenues) were manufacturing, wholesale and retail, mining, transportation, and construction.B Those are the industries most at risk if rates rise starting next year.

Moving forward, the S Corporation Association plans to take this new study and related materials up to Congress to continue to educate policymakers on the important role pass- through businesses play in job creation and investment.B The Congressional Budget Office predicts that failure to address the Fiscal Cliff will send the economy into recession in the short term.B The new Ernst & Young study shows that failure to stop just the top rates from rising has the potential to cause long term harm as well.B Itbs an important contribution to the on-going debate, and webre going to make sure itbs heard.

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