Robert Carroll’s study on pass-thru businesses continues to be a centerpiece in the tax policy discussion here in DC.
At yesterday’s Finance Committee hearing on the future of tax rates, Bill Rys from the National Federation of Independent Business did a great job of articulating just how many people work for pass-through businesses and why raising tax rates will hurt their ability to invest and create jobs. As Bill pointed out in his testimony:
Based on 2008 tax data, pass through businesses represented 95 percent of all business entities. These businesses employed a majority – 54 percent - of the total private sector workforce. In fact, in all but two states – Delaware and Hawaii - pass through businesses accounted for a majority of the private sector workforce. In six states - Idaho, Maine, Montana, South Dakota, Vermont, and Wyoming – they accounted for more than 60 percent of the private sector workforce. Pass through businesses also report a considerable amount of income. Between 2004 and 2008, individual owners of pass through businesses reported 54 percent of all business net income.
The whole hearing is worth reviewing, but here’s the Q&A that really caught our ear. Once again, S-Corp champ Olympia Snowe (R-ME) was in the middle of it:
Senator Snowe (R-ME): Another proposal offered was their version of corporate tax reform and require this conversion from S-Corps to C-Corps. How damaging would that be?
Rys: I think there’s a lot of concern for small business owners, they had a lot of success being able to set up their businesses as pass-through structures. It’s a much simpler tax system, much simpler business structure. Under the current code, no tax structure is simple but in comparison it’s certainly easier. Some of the concern our members have is if you reduce deductions to pay for that, it’s also going to have a negative impact on those pass through businesses. Their tax rates are going to go up not only because their tax rates go up, but because they may have lost a deduction that they may have relied on. So, it really puts small business owners on uneven footing. When we look at these pass-through businesses, they really do produce a lot of the private sector employment in this country - its 54 percent right now. There are six states with over 60 percent, including Maine and Montana. Montana is the highest in the country at 69 percent. So, there are a lot of employees working in these businesses and it’s a structure that is working very well for small business owners.
Snowe: As I understand it, there will be 20 million workers affected by this tax rate.
Rys: It would be a substantial number of the workforce. When we looked through our business data, the businesses most likely to get hit are the businesses that have between 20 and 250 workers. Those businesses account for a quarter of the American workforce–33.5 million workers. Those businesses are generating jobs. They’ve hit a rough patch but these businesses are creating jobs, generating opportunities, they are providing economic growth, and that’s going to be diminished if tax reform is done in a way that increases their rates and reduces the deductions that they rely on.
Chairman Baucus (D-MT): Mr. Rys, you got my attention. You said 69 percent.
Rys: Yes, of the employees that work in Montana, 69 percent of them work in pass-through businesses. It’s the highest in the country.
The Threat Spelled Out
Everybody talks about policy “uncertainty” these days — where is tax policy headed? How will the Affordable Care Act affect my labor costs? Does Dodd-Frank apply to me? These are all good questions that business owners are asking themselves.
But what about policy certainty? As in, unless Congress acts, we know tax rates on going up? That’s the message we hear from our membership, and that’s the threat the Wall Street Journal spelled out yesterday morning.
Entitled “The 2013 Tax Cliff — Business had better enjoy the next 16 months,” the editorial does a great job of articulating the massive tax hike facing S corporations, partnerships, and sole proprietorships just around the corner:
What this means is that millions of small-business owners had better enjoy the next 16 months, because come January 2013 they are going to get hit with a giant tax bill. Let’s call the expensive roll:
- First comes the new tax hikes that Mr. Obama proposed on Monday. Capping itemized deductions and exemptions for the rich would take $405 billion from the private economy for 10 years starting in 2013. Taxing carried interest would raise $18 billion, and repealing tax incentives for oil and gas production would get $41 billion.
- These increases would coincide with the expiration of the tax credits, 100% expensing provisions and payroll tax breaks in Mr. Obama’s new jobs program. This would mean a tax hit of $240 billion on small business and workers. That’s the downside of temporary tax breaks and other job-creation gimmicks: The incentives quickly vanish, and perhaps so do the jobs.
So even if the White House is right that its latest stimulus plan will create “millions of jobs” through 2012, by this logic a $240 billion tax hike on small businesses in 2013 would cost the economy jobs. This tax wallop would arrive when even the White House says the unemployment rate will still be 7.4%.
- January 2013 is also the same month that Mr. Obama wants the Bush-era tax rates to expire on Americans earning more than $200,000. That would raise the highest individual income tax rate to about 42%, including deduction phaseouts, from 35% today. Congress’s Joint Committee on Taxation found in 2009 that $437 billion of business income would be taxed at higher tax rates under the Obama plan. And since some 4.5 million small-business owners file their annual tax returns as subchapter S firms under the individual tax code, this tax increase would often apply to the same people who Mr. Obama is targeting with his new tax credits.
The capital gains and dividend taxes would also rise to an expected 20% rate from 15% today. The 10-year hit to the private economy for all of these expiring Bush rates: about $750 billion.
- Also starting in 2013 are two of ObamaCare’s biggest tax increases: an additional 0.9-percentage point levy on top of the 2.9% Medicare tax for those earning more than $200,000, and a new 2.9% surcharge on investment income, including interest income. This will further increase the top tax rate on capital gains and dividends to 23.8%, for a roughly 60% increase in investment taxes in one year.
The White House’s economic logic seems to be that its new spending and temporary tax cuts will so fire up investment and hiring in the next 16 months that the economy will be growing much faster in 2013 and could thus absorb a leap off the tax cliff. But this requires its own leap of faith.
All of this assumes that American business owners aren’t smart enough to look beyond the next few months. They can surely see the new burdens they’ll face in 2013, and they aren’t about to load up on new employees or take new large risks if they aren’t sure what their costs will be in 16 months. They can also reasonably wonder whether Mr. Obama’s tax hike will hurt the overall economy in 2013, another reason to be cautious now.
We couldn’t have said it better. Policy uncertainty is bad, but knowing that a policy is going to hurt your business is worse.