With a national
discussion underway about reforming Social Security, it is
timely to consider the impact of possible changes on the nation's
small businesses and entrepreneurs. Well-crafted reforms could aid
this vital sector, but a survey of economic research shows that
quick fixes like payroll tax hikes could be extremely damaging-not
only to entrepreneurship, but also to the economy's ability to
generate the jobs and growth needed to sustain Social
Security.
Why Focus on Small
Business and Entrepreneurship?
Small business
exercises an immense influence on the American economy. More than
99 percent of all U.S. employers are small, and they employ just
over half the private sector workforce. Such firms provide about
three-quarters of the nation's net new jobs and half of its
private-sector economic output. During recoveries from recent
recessions, small businesses have been even more crucial, supplying
virtually all of the net new jobs. For example, in 2000-2001, the
nation's largest companies suffered a net loss of over 150,000
jobs. During the same period, companies with fewer than 20
employees created over 1.1 million net new jobs.[1]
However, job and
output statistics alone tell only part of the story. While larger
businesses tend to create process innovations that
strengthen economic efficiency, smaller businesses and
entrepreneurs are responsible for the lion's share of
product innovations that create new businesses and
industries[2] Technological developments that appear
likely to play a central role in future U.S. economic
growth-such as biotechnology, nanotechnology, homeland security
technology, and breakthrough innovations in information
technology-have been closely linked to smaller
companies.
This is an unusual
feature of the American economy,[3] but it is not a new feature.
Of the 200 largest American companies in the late 1990s, 197 could
be traced back to entrepreneurial founders, according to one
study.[4]
Small firms are also
breaking paths in the rapidly globalizing economy. Between 1987 and
2003, the number of U.S. small-business exporters tripled to over
240,000, and these companies were 20 percent more productive,
experienced 20 percent faster job growth, and paid 15 percent
higher wages than the rest of American business.[5]
At the same time,
small business traditionally has offered a way into the economic
mainstream for younger and less-skilled workers, the economically
displaced, immigrants, and people leaving public assistance. In
every American community, small firms present the most vivid human
face of the economic system.
Consequently,
Americans have great respect for small businesses. A Gallup poll
found large majorities agreeing that small business represents
"one of the best ways to get ahead in America" and saying that they
strongly admired small-business owners. Indeed, 90 percent said
they would be pleased if a son or daughter started a small
business.[6] Surprisingly large majorities say that
small-business owners work harder (91 percent) and contribute
more to the community (82 percent) than "people like yourself"
do.[7]
These survey findings are essentially constant across age,
ethnicity, gender, socioeconomic status, rural/suburban/urban
characteristics, political philosophy, and partisan identification,
and they are far more positive than comparable survey results
from abroad. These public attitudes help to explain the deep
reserves of support that small business enjoys in Congress, state
legislatures, and other governmental institutions.
Economic studies bear
out the public perceptions about the value of smaller
companies and the characteristics of the individuals who propel
them. For example, economist William Bradford found that "black and
white entrepreneurs have more upward and less downward mobility in
the wealth distribution [of the U.S.] than black and white workers,
respectively."[8] Similarly, economist Vicenzo Quadrini found
that entrepreneurs do in fact accumulate more assets and
savings and generate more wealth than other individuals at their
same income levels.[9] An array of studies has confirmed that the
actions and decisions of entrepreneurs spearhead most new job
creation.[10]
The good news is that
there is enormous latent entrepreneurship in the United States. A
1998 survey of 25,000 individuals in 23 nations found that an
amazing 71 percent of U.S. respondents said that they would prefer
to be self-employed.[11] Even if half of these individuals were
not truly serious about self-employment, the total is still many
times larger than the 10 percent or so of Americans who are in fact
self-employed.
The bad news is that
self-employment and other forms of entrepreneurship are highly
sensitive to tax rates[12] and other macroeconomic factors, such as
the tax treatment of retirement benefits,[13] including Social Security
payroll taxes.
The challenge facing
the country is that current levels of Social Security benefits are
not sustainable using the system's present financing. Previous
efforts to shore up Social Security's financing have focused
primarily on increasing the number of individuals and types of
wages covered by payroll taxes and on increasing payroll tax
rates.
The research reviewed
here strongly suggests that if such measures are the central
thrusts of the next overhaul, Social Security taxes would likely
become a far larger threat to entrepreneurship, small
business, and job creation, which would in turn threaten the
nation's economic growth as well as Social Security's own
long-term revenue projections.
Marginal Tax Rates and
the Entrepreneur's Decision
To understand why this
is true, it is crucial to grasp the role of marginal tax
rates.
For an entrepreneur
contemplating a business venture, a central question is what the
marginal tax rate-the so-called tax on the "next dollar of
profit"-will be. Entrepreneurship obviously entails risks, and an
entrepreneur will not take them without a "risk premium"-in other
words, without rewards that are seen as appropriate.[14]
For example, in a
hypothetical but relatively typical entrepreneurial situation,
a business opportunity appears for an individual who is a
wage-earner. That opportunity seems likely to yield $100,000 in
taxable profit (after expenses and deductions) in the next tax
year. To participate in the opportunity, the entrepreneur would
need to sell some securities or perhaps take out a second mortgage
on a home. The risk for the entrepreneur is that these assets must
be pledged toward a business whose future success is ultimately
based on educated guesses.
By contrast, the taxes
facing the entrepreneur- the "subtractions" from the return that
the opportunity can offer-are the most knowable parts of the
entrepreneur's calculation. Assuming that the entrepreneur weighing
this $100,000 opportunity acts as a sole proprietor, a partner, or
part of a "pass-through" entity like an S corporation or an LLC,
the tax calculation might look like this:
-
Federal income
taxes. The "business
opportunity" income would likely fall into the 28 percent
personal income tax bracket, assuming that the entrepreneur's other
wage income does not push the entrepreneur into the 35 percent
bracket.
-
State income
taxes. These might total 6
percent. Various minor state and local taxes and licenses
might add another 1 percent. Nearly all of that 35 percent in state
and federal income tax would be contingent on the business's
making a profit.
-
Payroll
taxes. These must be paid
whether or not the business makes a profit. For wages up to the
$90,000 cap on federal payroll taxes for Social Security and
Medicare, the entrepreneur would owe 7.65 percent in payroll taxes
on the salary of each wage-earner in the new venture. If the
entrepreneur were self-employed in the new venture, the payroll
taxes would include an additional 7.65 percent on the
entrepreneur's wages for the "employee share," for a total of
15.3 percent. Above the $90,000 cap, this payroll tax would drop to
2.9 percent (for Medicare).
As a result, an
entrepreneur weighing this hypothetical opportunity as a
self-employment proposition would have to decide whether the
prospects looked good enough to pay 15.3 percent in taxes on
personal earnings up to $90,000 and, if the business made a profit,
another 35 percent in income taxes. If the business
opportunity cleared enough to pay the entrepreneur (or any
employees) more than $90,000 in salary, there would be a "success
reward."[15] The payroll taxes drop to 2.9 percent on
wages above that amount, making the marginal tax bite that much
smaller on those dollars.[16]
For the prospective
entrepreneur, this is a fairly dicey marginal tax rate profile. If
there is a "tipping point" in the entrepreneur's "go/no go"
decision, anecdotal evidence would suggest it is the 50
percent tax threshold-the level at which entrepreneurs
begin grumbling that "the government would be getting most of the
money." Current marginal tax rate profiles hover very close to
that 50 percent mark for many profitable business
opportunities that would generate less than $90,000. While the
rates drop after that due to the payroll tax cap, they rise again
at $319,000 when the "next dollar" of income falls into the 35
percent federal income tax bracket, nudging the marginal tax
profile again toward 50 percent.[17]
The other factor that
the entrepreneur can know with some certainty is the cost of the
money that would finance the transaction. For example, to finance
this hypothetical investment opportunity, the entrepreneur could
perhaps borrow the money at a 7 percent interest rate or withdraw
it from a personal investment that is paying 5 percent. In either
case, the entrepreneur would expect the returns from the business
opportunity to cover the interest payments (or lost investment
opportunity) plus a "risk premium" for taking the risk of
pursuing the business opportunity. Any time taxes go up, all
other things being equal, fewer entrepreneurial opportunities will
offer these risk premiums.
Extending the
hypothetical case a bit further, if the $100,000 opportunity
required the entrepreneur to bring $300,000 to the table, and
if that money cost the entrepreneur 6 percent (or $18,000) in
forgone interest or investment income for the year, then the
opportunity might need to yield at least $40,000 (13.3 percent) in
after-tax profit to justify the risk. "After all," the
entrepreneur thinks, "what if the opportunity doesn't work
out? I'd be out a piece of the $300,000-maybe a big piece-plus
whatever interest income I might otherwise have generated from it.
How much of a premium do I need from this opportunity to justify
that risk?"
Thus, if about $50,000
of the $100,000 anticipated gain is headed directly to
taxes,[18] the margin of error on the business
opportunity-whether the error is caused by changes in costs,
demand, interest rates, or simply poor management-is small.
Eliminating the $90,000 "cap" on earnings subject to Social
Security taxation, or raising the overall payroll tax rate, would
narrow or eliminate that margin of error.[19] The risks would look
increasingly large while the rewards would appear
increasingly small.
Calculations like
these are not often part of the public debate about economic
policy, but they ought to be. They represent key elements that
entrepreneurs will weigh before producing the jobs and economic
growth that the nation needs.[20]
Social Security's
Impact
on Marginal Rates
Looking ahead,
entrepreneurs may well find themselves nostalgically remembering
marginal tax rate calculations like those in the
example.
Payroll Tax
Increases. Payroll tax increases
to support Social Security are very much on the table. According to
the Social Security Administration, if Social Security benefits
remain on their present course, achieving long-term solvency in
Social Security financing through payroll taxes would require a 15
percent increaseif enacted now, a 21 percent increase if enacted in
2018, and a 42 percent increase if enacted in 2042.[21]
The reasons for this
are increasingly well-known. While 16 workers supported each Social
Security beneficiary in 1950, lower birth rates and lengthening
life expectancies have since shrunk the ratio to about three
workers per beneficiary. If present trends continue, the ratio will
drop to two workers per beneficiary within a generation.
Social Security's
problems are drawing closer. Once they begin, they will grow
quickly and exert enormous stress on the economy and on taxpayers.
The system's cash flow will be inadequate to meet promised benefits
by 2017 and will grow steadily worse thereafter. Just covering
Social Security's cash flow problem over the next 75 years would
require an additional $4 trillion, according to the system's
trustees-$300 billion higher than the previous year's estimate.[22]
Yet even that
unimaginable sum would not eliminate all of Social Security's
financial needs. The Federal Reserve Board estimates that
setting the system fully right would cost more than $10 trillion.[23]
Trying to address
these problems through higher payroll taxes would keep the system
hostage to the same demographic trends that are undermining it now:
There would still be fewer and fewer workers struggling to finance
benefits for more and more recipients. Workers would get smaller
and smaller returns on their tax "investments" after they retired.
If life expectancies increase, birthrates fall further, or
immigration of younger people drops below projections, further
upward revisions in payroll taxes will be needed.
Additional Tax
Increases. There is another
problem with depending on payroll taxes: Doing so runs a high risk
of requiring higher taxes outside of Social
Security.
Social Security has a
funding surplus now. The system takes in more taxes than it needs
to pay benefits, but that extra money is not being saved. It
is being used to fund other functions of government. As the Social
Security surplus starts shrinking after 2008, financial pressure on
the overall federal budget will increase. All of the programs
that were being financed with Social Security money will begin
losing their access to it. The payroll tax increases now being
discussed would cover the costs of paying Social Security
benefits, but the Social Security surplus that the rest of
the government has been using would still shrink and finally
disappear. What will make up for that funding shortfall?
Furthermore, Social
Security is not the only factor exerting upward pressure on
the federal budget. The budget will also be squeezed notably by
health care costs. Federal health care outlays for both Medicare
and Medicaid are rising. Today, that spending is roughly equal to
Social Security, at about 4 percent of the nation's gross domestic
product (GDP). By 2050, while Social Security spending rises
to 6.5 percent of GDP, Medicare and Medicaid spending will rise to
12 percent of GDP.[24] This system is unsustainable with
its present financing.
Unless the rest of the
federal budget can be cut back substantially (which is unlikely,
based on historical experience), payroll tax increases for
Social Security could well be followed or accompanied by
significant increases in other federal
taxes.
Putting Social
Security on a sound financial footing will provide more
flexibility for addressing the enormous challenges ahead on health
care financing and the overall federal budget. But ignoring
the Social Security financial crisis or taking half-measures
that allow it to deepen almost guarantees that these future fiscal
problems will make one another worse-and lead to significant tax
increases.
This leads to the key
long-term issue: Even the most ambitious proposals for reforming
Social Security, not to mention Medicare, still depend heavily on
taxes that future workers will pay.
What if there are not
enough future workers? What if all the calculations about the
number of future workers are too high? This could happen if the key
job-creating mechanism in the economy slows down or stops. That
mechanism, of course, consists principally of entrepreneurial
activities.
If the tempo of job
creation by entrepreneurs slows to the point that new jobs stop
appearing in large enough numbers, all of the payroll and income
taxes supporting all of these programs and functions could be
forced into a destructive spiral in which ever-lower revenues lead
to ever-higher rates-a spiral that could start feeding on
itself.
Yet that is precisely
the economic risk the nation would be taking by increasing the
marginal tax rate profiles of entrepreneurial activity.
Pre-Funding Social
Security
There is, however, one
very good reform option that can help to prevent this from
happening.
A big difference
between Social Security and much of the rest of federal spending is
that Social Security retirement benefits can be pre-funded,
like a typical private-sector (or government) retirement plan.[25]
Doing so, particularly as part of a package of reforms, would
greatly lessen Social Security's long-term squeeze on federal
revenues. It would also help to create incentives for
entrepreneurship by improving the retirement income prospects for
entrepreneurs and those who work for them.
Pre-funding Social
Security could be accomplished by diverting a portion of
payroll taxes into personal retirement accounts that would be
invested in broad portfolios of stocks and bonds, comparable to
those used by other pension plans. Such an approach to pre-funding
government retirement income programs has been implemented in
recent years in Australia, Sweden, the United Kingdom, and a number
of countries in Latin America and Central and Eastern Europe. In
many of these nations, significant support for pre-funding has come
from both business and labor. Indeed, the federal government itself
offers a Thrift Savings Plan to its own employees that is based on
similar principles.
However, there
continues to be a hesitancy about pre-funding Social Security
through personal accounts. The trouble with waiting to enact this
reform is that, with each passing year, the "miracle of compound
interest" has one less year to operate. Just as it is relatively
inexpensive to fund a retirement starting at age 20 and very
expensive to fund one at age 50, so the costs of waiting to
pre-fund Social Security will grow. Each year of delay gives the
investments in a personal account less time to work, resulting in
smaller balances. This in turn puts greater pressure on payroll
taxes to make up the difference.
Congress has a window
of opportunity to put Social Security on a sounder fiscal footing
by shifting toward pre-funding, perhaps setting a precedent that
can help financially to sustain other entitlement programs. Or
Congress can let the window close. It can continue to address the
cash flow problems in Social Security and other entitlement
programs through higher payroll taxes, and it can continue to
ignore the effects on the larger federal budget picture and
procrastinate further on the unfunded liabilities.
Taking the latter path
not only would mean higher Social Security payroll taxes, but also
would likely mean more pressure to increase marginal tax rates to
support other government functions. It could also mean a shortfall
in the jobs on which everyone is depending to keep the whole system
afloat.
The Outlook for
Entrepreneurial Growth
A search of the
economic literature does not reveal any studies examining the
impact on entrepreneurship of a series of marginal rate
increases of the magnitude that such a policy of drift would
eventually entail, perhaps because it would be so unthinkable to
most economists. However, there is some important
evidence.
-
A recent study of tax
differences among advanced industrial countries found that
during the 1990s, a tax increase of 12.8 percent led to 122
fewer hours worked per adult per year, a 4.9 percent drop in the
ratio of employment to population, and a rise in off-the-books
business activities in the "shadow economy" equivalent to 3.8
percent of GDP. Worse, it led to a 10 percent-30 percent loss
of employment in the retail, wholesale, automotive repair, food
service, and hotel industries-jobs most likely to be held by
poorer workers, including minorities and immigrants.[26]
-
A long-term study of
Sweden showed entrepreneurial activity essentially shutting
down once overall marginal rates rose well above 50 percent
and estate taxes increased.[27]
-
A panel study of 30
prosperous countries showed a very strong relationship between
rising government shares of gross domestic product, in
large part reflecting tax rates, and falling levels of
self-employment.[28]
-
In the U.S., another
study has shown a significant drop in hiring by
entrepreneurial businesses and the salaries paid to
employees at such businesses as marginal rates rise.[29]
All of this meshes
with anecdotal evidence from entrepreneurs. As marginal rates rise
noticeably above 50 percent, the complaints of entrepreneurs
seem to shift from strong skepticism ("It looks like the government
would be making more on this than I would.") to outright rejection
("Why should I do it? I'd just be working for the
government.").
A Social Security
reform plan that is blind to these impacts could be a disaster for
the nation's economic growth and the efficient use of its
resources.
Entrepreneurs and
Retirement
While entrepreneurs
are important allocators of capital and other resources, they are
also individuals with their own retirement needs. Retirement
income sources in the U.S. are sometimes described as legs of a
"three-legged stool," with Social Security benefits as one leg and
pensions and personal savings as the other two. Entrepreneurs and
those who work for them do not fare especially well with respect to
any of these legs, and the prospects are not
promising.
Pensions.
Most people in
small businesses do not have pensions. While 64 percent of
full-time employees at mid-size to large-size businesses with more
than 100 employees are offered employer-supported retirement
benefits, only 34 percent of full-time workers in small private
establishments are covered by a retirement plan.[30] Among
businesses with one to nine employees, the figure drops to 22
percent.[31]
Nor does it appear to
be getting much better. Of those small businesses without pension
plans, about half have never heard of Simplified Employer
Pensions (SEP), which were intended by Congress to address this
need, and only 3 percent of these companies say they are "very
familiar" with SEPs. One-third have never heard of Savings
Incentive Match Plan for Employees of Small Employers (SIMPLE),
supposedly the other small-business pension fix, and only 11
percent express strong familiarity with it. Only 7 percent of small
businesses without pension plans say that they are very likely
to add them, and 43 percent say that they are very unlikely to do
so.[32]
The reasons stated for
this are important. Nearly three-quarters of the non-sponsoring
businesses say they would be more willing to offer pensions if
their companies were more profitable. Studies based on financial
data from smaller companies back up this assertion, consistently
showing a strong relationship between the companies'
profitability and the employee benefits, like pension plans
and health insurance, that they offer.[33] Taxes are obviously a
major factor in determining profitability for many
companies.
The next two most
frequently cited reasons are also quite relevant to retirement
income reform proposals: Two-thirds of the companies without
pension plans say they would be more likely to offer them if
the plans did not require employer contributions, and 56 percent
say they would be more likely to do so if there were business tax
credits for such plans.[34]
Savings.
Most Americans,
including most entrepreneurs, do not save enough money for
retirement. Federal incentives like "regular" IRAs, Roth IRAs,
expanded deductibility for dividend payments, and a
multimillion-dollar Choose to Save education campaign mounted by a
huge public- private partnership are not working. Only 18
percent of the American people have more than $100,000 in
private savings dedicated to their retirement, and only 38 percent
have more than $25,000.[35] While some of those with higher
savings may be younger workers who will continue adding to
their savings, these amounts still represent very little money
for periods of retirement that are likely to span 10-15
years.
Figures on personal
savings for retirement are not generally available by business
size, but a study by the National Association for the Self-Employed
found that 78 percent of the entrepreneurs that it represents had
saved less than $100,000 for retirement, although virtually
none of them had private-sector pensions and their median age was
46.[36] When questioned closely in a major
national poll on saving, a majority of those not saving enough (in
other words, a majority of a majority) said that they do not save
because they simply do not have surplus cash to allocate to
savings. This is particularly true of people at middle-income to
lower-income levels.[37]
Social Security
Benefits. Since entrepreneurs
and those whom they hire are less likely than employees of larger
companies to have pensions and no more likely to have adequate
retirement savings, they would be more seriously and
disproportionately affected by cuts in Social Security
benefits. Equally disturbing, such benefit cuts would
make retirement planning an even more daunting challenge for
entrepreneurs and small business. In the words of David Birch, a
pioneer in modern studies of job creation:
The average graduate
from high school or college will have 13 different jobs during
their working life. They will average 3½ years on each job.
Clearly they are going to have to build a retirement plan
themselves, since it takes at least three years to get vested under
retirement law.… The majority of people in college or high
school are very much into free agency.… They view themselves
as providing for their own retirement.… They do whatever it
takes, but they are going to have to build their retirement fund.[38]
If retirement income
prospects were to discourage many in this cohort from taking up
entrepreneurship in favor of "safer" choices like long-term
employment in large enterprises (even if that were a realistic
option), the consequences for the nation's economic efficiency,
openness, growth, and innovation would be damaging. Again, any
major slowdowns in the nation's engine of job creation, which
is largely powered by entrepreneurs, would have enormously
negative consequences for Social Security.
Principles for
Reform
Taken together, these
findings suggest five important principles for retirement policy
and Social Security reform:
-
Efforts to expand
pension coverage are unlikely to succeed unless the coverage is
significantly tax-advantaged and easily administered, employer
contributions are minimized, and the overall economic climate is
positive.
-
Simply providing
new opportunities to save will not solve the retirement
income dilemma. Individuals already have many attractive ways
to save for retirement, but these opportunities are underutilized
by many middle-income and lower-income citizens, who say that they
do not have enough money left to save for retirement after they pay
for their basic needs.
-
Social Security
benefits are likely to be a
more important source of retirement income for entrepreneurs and
those who work in smaller companies than for other
Americans.
-
Some way must be found
to sustain and, if possible, increase retirement
benefits-one that does not increase payroll taxes and that does
not assume that voluntary contributions will be made to a savings
plan simply because that plan exists.
-
Raising taxes on
entrepreneurs is not the way out of
the dilemma. If Congress tries to "solve" Social Security's
financial problems by raising marginal tax rates, there will be
fewer entrepreneurs. If there are fewer entrepreneurs, there
will be fewer new jobs created and slower economic growth.
With fewer jobs and slower growth, Social Security's problems will
become far worse.
The Best Reform Option
for Entrepreneurs
Of all the Social
Security reform proposals currently being discussed, the one
that best fits all of these criteria is diverting a portion of
existing payroll taxes into personal accounts that workers
would own and control themselves. There are several key
reasons for this.
-
Personal accounts that
are developed from existing payroll taxes would likely increase
Social Security benefits while avoiding major payroll tax
increases. This meets two of the entrepreneur's needs
simultaneously. It could decisively improve the rate of return that
entrepreneurs would achieve for their own retirements,
and it could help to avoid marginal tax increases that would create
an unfavorable economic climate for entrepreneurial
activities. Both factors would create strong incentives for
entrepreneurship.
-
The personal account
option would not require the entrepreneur, as an employer,
to increase the contribution level for employee pensions or savings
funds. Yet personal accounts would likely offer those employees a
better rate of return than they could expect from the existing
Social Security system. This would make working for an
entrepreneurial business-even one without a pension plan (or one
with a plan that requires several years to vest)-a more
attractive option for potential employees.
-
The personal account
option directly addresses the two key structural flaws in the
current system: the demographic squeeze of fewer workers
supporting more retirees for longer periods of time and the huge
unfunded liability. Payroll tax increases would not fundamentally
address either structural problem. Under a personal account system,
benefits would rise as the value of investments rose. The benefits
would not depend on the forbearance of workers under ever-heavier
tax burdens or on some unlikely spurt of population growth. What
are often called the "transition costs" to a personal account
system are seen more accurately as an explicit recognition of
existing liabilities in a system that is paying down those
liabilities and pre-funding its future pension benefits like most
pension plans. Moving toward pre-funding and paying down
unfunded liabilities are important steps in reducing the downstream
pressure for higher taxes.
-
Since personal
accounts would create assets that could be passed on to heirs, the
number of individuals receiving inheritances (or larger
inheritances) would rise. This would aid the retirement income
prospects of the next generation. Research has also
shown that individuals receiving inheritances are far more likely
to engage in entrepreneurial activities than is the population as a
whole.[39] Thus, personal accounts, in and of
themselves, would indirectly increase
entrepreneurship.
-
Because entrepreneurs
focus on economic risks, they are likely to make informed choices
about whether or not to choose personal accounts and to convey
their thinking to their employees. This kind of constructive
scrutiny will be good for the system. However, entrepreneurs will
also understand, and be accepting of the fact, that some
people may choose the "known" of the traditional Social
Security system over the relative "unknowns" of personal
accounts.
-
A personal account
system would help to curtail the current practice of having the
Treasury Department cover its borrowing from the Social Security
system by issuing non-publicly traded government securities (IOUs)
to that system. In contrast to this practice, personal account
funds would be invested in private and public equities markets,
where money is substantially more transparent and fungible. Over
time, therefore, personal accounts would likely increase the
capital available for entrepreneurial ventures.
In sum, personal
accounts offer two fundamental advantages for small business:
actions that the government would not have to take
(unnecessarily raising taxes or cutting Social Security benefits)
and results that the private sector would generate (enhanced
entrepreneurship, strengthened capital markets, and improved
retirement incomes). In the end, empowering entrepreneurs in this
way would benefit the entire nation as additional jobs were created
and economic growth was sustained.
As for the Social
Security system itself, perhaps no one has offered a better
appraisal than its founder, President Franklin D.
Roosevelt:
Social Security is a
development towards [a] goal, rather than a finished product. We
should be constantly seeking to perfect and strengthen it in the
light of our accumulating experience and growing appreciation of
social needs.[40]
James Morrison,
Ph.D., has specialized in small-business and entrepreneurship
policy for over 20 years. He is a trade association executive in
Washington, D.C.
[1]The figures cited are
for net job creation by firm size (subtracting job losses from job
gains) covering the 2000-2001 period. They show that businesses
with one-19 employees created 1.1 million net new jobs, businesses
with 20-500 employees created 39,000 net new jobs, and businesses
with more than 500 employees lost a net 151,000 jobs. See U.S.
Department of Commerce, Bureau of the Census, "Establishment
and Employment Changes from Births, Deaths, Expansions, and
Contractions by Employment Size of the Enterprise for the United
States and All States, Totals: 2000-2001," data type code 11,
columns D-J, at www.census.gov/csd/ susb/usst00_01.xls (May
19, 2005). Over the past 15 years, the proportion of net new jobs
created annually by small business has ranged from 64 percent to
100 percent, averaging about 77 percent, and the proportion of
U.S. gross domestic product attributable to businesses with fewer
than 500 employees has ranged from 49 percent to 52 percent.
See Joel Popkin, "Small Business Share of Economic Growth," U.S.
Small Business Administration, Office of Advocacy, Small
Business Research Summary No. 211, January 2002, at
www.sba.gov/advo/ research/rs211.pdf (May 19,
2005).
[2]Zoltan Arcs and David
Audretsch, Innovation and Small Firms (Cambridge, Mass.: MIT
Press, 1996).
[3]Richard Nelson,
National Innovation Systems (Oxford, U.K.: Oxford University
Press, 1993).
[4]Courtney Purrington and
Kin Bettcher, From the Garage to the Boardroom: The
Entrepreneurial Roots of America's Largest Corporations
(Washington, D.C.: National Commission on Entrepreneurship,
2001).
[5]U.S. Department of
Commerce, Office of Trade and Economic Analysis, Exporter Data
Base.
[6]William J. Dennis, Jr.,
The Public Reviews Small Business (Washington, D.C.: NFIB
Education Foundation, August 2004), p. 17. The figure is based on a
2004 poll of 750 American adults.
[8]William D. Bradford,
"The Wealth Dynamics of Entrepreneurship for Black and White
Families in the US," Review of Income and Wealth, Vol. 49,
No. 1 (March 2003), pp. 89-116.
[9]Vicenzo Quadrini, "The
Importance of Entrepreneurship for Wealth Concentration and
Mobility," Review of Income and Wealth, Vo. 45, No. 1 (March
1999), pp. 1-20.
[10]For example, see Zoltan
Acs and Catherine Armington, "Job Flow Dynamics in the Service
Sector," U.S. Department of Commerce, Bureau of the Census,
Center for Economic Studies Research Paper No. 99-14, 1999;
Catherine Armington, Alicia Robb, and Zoltan Acs, "Measures of Job
Flow Dynamics in the U.S.," Department of Commerce, Bureau of the
Census, Center for Economic Studies Research Paper No.
99-1, 1999; John Baldwin, Timothy Dunne, and John Haltiwanger, "A
Comparison of Job Creation and Job Destruction in Canada and
the United States," Review of Economics and Statistics, Vol.
80, No. 3 (August 1998), pp. 347-356; David Birch and James Medoff,
"Gazelles," in Lewis Solomon and Alec Levenson, Labor
Markets, Employment Policy and Job Creation (Boulder,
Colo., and London: Westview Press, 1994), pp. 159-165; and Robert
E. Hall, "The Concentration of Job Destruction," National Bureau of
Economic Research Working Paper No. 7025, 1999.
[11]David Blanchflower,
Andrew Oswald, and Alois Stutzer, "Latent Entrepreneurship Across
Nations," European Economic Review, Vol. 45, Nos. 4-6 (May
2001), pp. 680-691. The survey source was the International Social
Survey Programme Module on Work Orientations. Poland ranked
highest, with 80 percent saying that they preferred
self-employment, and Portugal was second, with 73 percent.
Self-employment was favored by a majority of respondents in 11 of
the 23 nations and by near majorities in three others. Norway
ranked last, with a still remarkable 27 percent saying they
preferred self-employment-more than four times that nation's actual
self-employment rate.
[12]Donald Bruce, Ph.D.,
and Tami Gurley, "Taxes and Entrepreneurial Activity; An Empirical
Investigation Using Longitudinal Tax Return Data," U.S. Small
Business Administration, Office of Advocacy Research Study
No. 252, March 2005, at
www.sba.gov/advo/research/rs252tot.pdf (May 19, 2005);
Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey S.
Rosen, "Personal Income Taxes and the Growth of Small Firms," in
James Poterba, ed., Tax Policy and the Economy, Vol. 15
(Cambridge, Mass.: MIT Press, 2001), pp. 121-147; William Gentry
and R. Glenn Hubbard, "Tax Policies and Entrepreneurial
Entry," American Economic Review, Vol. 90, No. 2 (May 2000),
pp. 283-287; Roger H. Gordon and Julie Berry Cullen, "Taxes and
Entrepreneurial Activity: Theory and Evidence for the U.S.,"
National Bureau of Economic Research Working Paper No. 9015,
2002; and Simon C. Parker and Martin T. Robson, "Explaining
International Variations in Self-Employment: Evidence from a
Panel of OECD Countries," Southern Economic Journal, Vol.
71, No. 2 (June 2004), pp. 287-301.
[13]Laura Power and Mark
Rider, "The Effect of Tax-Based Savings on the Self-Employed," U.S.
Department of the Treasury, Office of Tax Analysis Paper No.
84, July 1999.
[14]Douglas Holtz-Eakin,
Harvey S. Rosen, and Robert Weathers, "Horatio Alger Meets the
Mobility Tables," Small Business Economics, Vol. 14,
No. 4 (October 2000), pp. 243-274.
[15]By eliminating this
"success reward," proposals to remove the current $90,000 cap on
Social Security taxes would substantially weaken the
incentives for entrepreneurial activity in this investment
range.
[16]The entrepreneur
obviously will have to consider other factors besides taxes. Also,
if the business loses money, there is some "risk sharing" possible
with the federal government in the form of loss carry-forwards and
capital losses. But the critical impact of the failure would be
felt in the first year by the entrepreneur, however much that
failure might lower the entrepreneur's taxes in future years.
The taxes also might vary upward, if the alternative minimum tax
(AMT) entered the picture, or downward, if various additional
business credits and deductions did. The hypothetical example
somewhat offsets the latter possibility by stipulating that
the income is in the 28 percent bracket rather than a higher
bracket. In any event, the example is intended simply as a
reasonable hypothetical case for purposes of
illustration.
[17]Thus, Martin Feldstein
argues that even the current level of Social Security taxation
substantially distorts occupational choice and effort. See Martin
Feldstein, "The Missing Piece in Policy Analysis: Social Security
Reform," American Economic Review, Vol. 86, No. 2 (May
1996), pp. 1-14.
[18]Again, this assumes
that the taxpayer avoids the AMT and has no additional credits or
deductions. See footnote 16.
[19]Sue Miller, CPA, of
Frank and Company, Certified Public Accountants, McLean, Virginia,
kindly offered suggestions for structuring this hypothetical
example, based on client experience. However, any omissions or
errors are solely those of the author.
[20]On an economy-wide
basis, just lifting the cap could cost 3 million small businesses
$242 billion from 2005-2009, according to a recent Heritage
Foundation analysis, which is consistent with the August 2004
Congressional Budget Office baseline. See Norbert J. Michel,
Ph.D., and J. Scott Moody, "Raising the Social Security Cap Would
Hurt Small Business," Heritage Foundation WebMemo No. 694,
March 17, 2005, at
www.heritage.org/Research/SocialSecurity/wm694.cfm. It is
also worth mentioning that, proportionally, payroll taxes weigh
most heavily on lower-income workers. This is because many
low-income workers pay little or no income tax but still must pay
payroll taxes.
[21]See James Lockhart,
Deputy Commissioner of Social Security, testimony before the
Committee on Ways and Means, U.S. House of Representatives, January
26, 2004, Chart 13, at
www.ssa.gov/legislation/LockhartHearing_files/frame.htm#slide0092.htm
(May 19, 2005).
[22]Social Security
Administration, The 2005 Annual Report of the Board of Trustees
of the Federal Old-Age and Survivors Insurance and Disability
Insurance Trust Funds, March 23, 2005, p. 2, at
www.socialsecurity.gov/OACT/TR/TR05/tr05.pdf (May 19,
2005).
[23]See Alan Greenspan,
"Future of the Social Security Program and Economics of
Retirement," testimony before the Special Committee on Aging, U.S.
Senate, March 15, 2005.
[24]Congressional Budget
Office, "Budgetary Perspectives on the Outlook for Social
Security," testimony before the Committee on the Budget, U.S. House
of Representatives, February 9, 2005, pp. 3-5.
[25]Pre-funding solutions
for Medicare and Medicaid, while technically possible, have not
been widely discussed. Pre-funding most other elements of
government spending (other than capital spending on highways,
airports, and the like) is probably impossible.
[26]Steven Davis and Magnus
Henrekson, "Tax Effects on Work Activity, Industry Mix and Shadow
Economy Size: Evidence from Rich Country Comparisons," National
Bureau of Economic Research Working Paper No. 10509, May
2004.
[27]Gunnar du Reitz and Dan
Johansson, "Skatterna, foretagandet och tillvaxten" ("Taxes,
Entrepreneurship, and Small Firm Growth"), Ekonomiska Samfundets
Tidskrift (Journal of the Economic Society of Finland), Vol.
56, No. 2 (2003), pp. 99- 110. See p. 125 for a summary in English.
Another study of Sweden with congruent findings is Stephan Fosler,
"Do Lower Taxes Stimulate Self-Employment?" Small Business
Economics, Vol. 19, No. 2 (September 2002), pp. 135-145, esp.
Section 3.
[28]Fosler, "Do Lower Taxes
Stimulate Self-Employment?" esp. Section 2. A second study of
marginal tax rates in 15 such well-off countries over a 15-year
period found that "The results for the tax variables are remarkably
consistent.… There is a great sensitivity of pretax income
to effort, representing the returns from
'entrepreneurship.'… [T]he appropriate policy would appear
to be to reduce the marginal tax rate." See Martin T. Robson and
Colin Wren, "Marginal and Average Tax Rates and the Incentive for
Self-Employment," Southern Economic Journal, Vol. 65, No. 4
(April 1999), pp. 757-780.
[29]Robert Carroll, Douglas
Holtz-Eakin, Mark Rider, and Harvey Rosen, "Income Taxes and the
Entrepreneur's Use of Labor," Journal of Labor Economics,
Vol. 18, No. 2 (April 2000), pp. 324-350. The authors make the
interesting observation that the findings "raise the possibility
that taxes on high-income entrepreneurs may be shifted in part to
lower-income employees, leading to counterintuitive effects on the
distribution of after-tax income." In other words, the effect of
marginal rate increases may be to hurt the employment prospects and
income of low-income workers the most.
[30]Employee Benefit
Research Institute and American Savings Education Council, The
2003 Small Employer Retirement Survey (Washington, D.C.:
Employee Benefit Research Institute, 2003), p. 1.
[31]Employee Benefit
Research Institute, EBRI Notes, Vol. 22, No. 1 (January
2001). Data compiled from U.S. Department of Commerce, Bureau of
the Census, Current Population Surveys, March 1995-March
2000. The figures are for 1999.
[32]Employee Benefit
Research Institute and American Savings Education Council, The
2003 Small Employer Retirement Survey, p. 3.
[33]William J. Dennis, Jr.,
"Wages, Health Insurance and Pension Plans: The Relationship
Between Employee Compensation and Small Business Owner Income,"
Small Business Economics, Vol. 15, No. 2 (June 2000), pp.
247-263.
[35]Ruth Helman and Variny
Paladino, "Will Americans Ever Become Savers?" Employee Benefit
Research Institute Issue Brief No. 268, April 2004,
p. 5.
[36]National Association
for the Self-Employed, "Social Security and the Self-Employed,"
testimony before National Commission on Retirement Policy,
Center for Strategic and International Studies, May
1997.
[37]For example, see
Employee Benefit Research Institute, American Savings Education
Council, and Matthew Greenwald & Associates, Inc., Retirement
Confidence Surveys, 1996-2004. In the 2004 survey, 60 percent of
those who were not willing to save more and 55 percent of those who
were willing cited "can't afford cut back/spend less" or "have
other priorities now" as the reasons they were not currently doing
so. Another quarter of each group said that they were already
saving enough, a statement that was empirically untrue for most of
them. (See Figure 12 in the 2004 survey).
[38]David Birch, interview
with The Wall Street Journal, May 24, 1999, p.
R30.
[39]Douglas Holtz-Eakin,
David Joulfain, and Harvey S. Rosen, "Entrepreneurial Decisions and
Liquidity Constraints," RAND Journal of Economics, Vol. 25,
No. 2 (Summer 1994), pp. 334-347.
[40]Quoted in John Breaux,
"Rising to the Challenge," The New Democrat, Vol. 10, No. 6
(November 1998), p. 29.
[18]Again, this assumes
that the taxpayer avoids the AMT and has no additional credits or
deductions. See footnote 16.
[19]Sue Miller, CPA, of
Frank and Company, Certified Public Accountants, McLean, Virginia,
kindly offered suggestions for structuring this hypothetical
example, based on client experience. However, any omissions or
errors are solely those of the author.
[20]On an economy-wide
basis, just lifting the cap could cost 3 million small businesses
$242 billion from 2005-2009, according to a recent Heritage
Foundation analysis, which is consistent with the August 2004
Congressional Budget Office baseline. See Norbert J. Michel,
Ph.D., and J. Scott Moody, "Raising the Social Security Cap Would
Hurt Small Business," Heritage Foundation WebMemo No. 694,
March 17, 2005, at
www.heritage.org/Research/SocialSecurity/wm694.cfm. It is
also worth mentioning that, proportionally, payroll taxes weigh
most heavily on lower-income workers. This is because many
low-income workers pay little or no income tax but still must pay
payroll taxes.
[21]See James Lockhart,
Deputy Commissioner of Social Security, testimony before the
Committee on Ways and Means, U.S. House of Representatives, January
26, 2004, Chart 13, at
www.ssa.gov/legislation/LockhartHearing_files/frame.htm#slide0092.htm
(May 19, 2005).
[22]Social Security
Administration, The 2005 Annual Report of the Board of Trustees
of the Federal Old-Age and Survivors Insurance and Disability
Insurance Trust Funds, March 23, 2005, p. 2, at
www.socialsecurity.gov/OACT/TR/TR05/tr05.pdf (May 19,
2005).
[23]See Alan Greenspan,
"Future of the Social Security Program and Economics of
Retirement," testimony before the Special Committee on Aging, U.S.
Senate, March 15, 2005.
[24]Congressional Budget
Office, "Budgetary Perspectives on the Outlook for Social
Security," testimony before the Committee on the Budget, U.S. House
of Representatives, February 9, 2005, pp. 3-5.
[25]Pre-funding solutions
for Medicare and Medicaid, while technically possible, have not
been widely discussed. Pre-funding most other elements of
government spending (other than capital spending on highways,
airports, and the like) is probably impossible.
[26]Steven Davis and Magnus
Henrekson, "Tax Effects on Work Activity, Industry Mix and Shadow
Economy Size: Evidence from Rich Country Comparisons," National
Bureau of Economic Research Working Paper No. 10509, May
2004.
[27]Gunnar du Reitz and Dan
Johansson, "Skatterna, foretagandet och tillvaxten" ("Taxes,
Entrepreneurship, and Small Firm Growth"), Ekonomiska Samfundets
Tidskrift (Journal of the Economic Society of Finland), Vol.
56, No. 2 (2003), pp. 99- 110. See p. 125 for a summary in English.
Another study of Sweden with congruent findings is Stephan Fosler,
"Do Lower Taxes Stimulate Self-Employment?" Small Business
Economics, Vol. 19, No. 2 (September 2002), pp. 135-145, esp.
Section 3.
[28]Fosler, "Do Lower Taxes
Stimulate Self-Employment?" esp. Section 2. A second study of
marginal tax rates in 15 such well-off countries over a 15-year
period found that "The results for the tax variables are remarkably
consistent.… There is a great sensitivity of pretax income
to effort, representing the returns from
'entrepreneurship.'… [T]he appropriate policy would appear
to be to reduce the marginal tax rate." See Martin T. Robson and
Colin Wren, "Marginal and Average Tax Rates and the Incentive for
Self-Employment," Southern Economic Journal, Vol. 65, No. 4
(April 1999), pp. 757-780.
[29]Robert Carroll, Douglas
Holtz-Eakin, Mark Rider, and Harvey Rosen, "Income Taxes and the
Entrepreneur's Use of Labor," Journal of Labor Economics,
Vol. 18, No. 2 (April 2000), pp. 324-350. The authors make the
interesting observation that the findings "raise the possibility
that taxes on high-income entrepreneurs may be shifted in part to
lower-income employees, leading to counterintuitive effects on the
distribution of after-tax income." In other words, the effect of
marginal rate increases may be to hurt the employment prospects and
income of low-income workers the most.
[30]Employee Benefit
Research Institute and American Savings Education Council, The
2003 Small Employer Retirement Survey (Washington, D.C.:
Employee Benefit Research Institute, 2003), p. 1.
[31]Employee Benefit
Research Institute, EBRI Notes, Vol. 22, No. 1 (January
2001). Data compiled from U.S. Department of Commerce, Bureau of
the Census, Current Population Surveys, March 1995-March
2000. The figures are for 1999.
[32]Employee Benefit
Research Institute and American Savings Education Council, The
2003 Small Employer Retirement Survey, p. 3.
[33]William J. Dennis, Jr.,
"Wages, Health Insurance and Pension Plans: The Relationship
Between Employee Compensation and Small Business Owner Income,"
Small Business Economics, Vol. 15, No. 2 (June 2000), pp.
247-263.
[35]Ruth Helman and Variny
Paladino, "Will Americans Ever Become Savers?" Employee Benefit
Research Institute Issue Brief No. 268, April 2004,
p. 5.
[36]National Association
for the Self-Employed, "Social Security and the Self-Employed,"
testimony before National Commission on Retirement Policy,
Center for Strategic and International Studies, May
1997.
[37]For example, see
Employee Benefit Research Institute, American Savings Education
Council, and Matthew Greenwald & Associates, Inc., Retirement
Confidence Surveys, 1996-2004. In the 2004 survey, 60 percent of
those who were not willing to save more and 55 percent of those who
were willing cited "can't afford cut back/spend less" or "have
other priorities now" as the reasons they were not currently doing
so. Another quarter of each group said that they were already
saving enough, a statement that was empirically untrue for most of
them. (See Figure 12 in the 2004 survey).
[38]David Birch, interview
with The Wall Street Journal, May 24, 1999, p.
R30.
[39]Douglas Holtz-Eakin,
David Joulfain, and Harvey S. Rosen, "Entrepreneurial Decisions and
Liquidity Constraints," RAND Journal of Economics, Vol. 25,
No. 2 (Summer 1994), pp. 334-347.
[40]Quoted in John Breaux,
"Rising to the Challenge," The New Democrat, Vol. 10, No. 6
(November 1998), p. 29.