May 6, 2010

May 6, 2010 | Testimony on Taxes

Small Businesses Face Steep Tax Hikes Unless Congress Acts Soon

Testimony before
Committee on Small Business
United States House of Representatives

May 5, 2010

 Madame Chairwoman, Members of the Committee, thank you for the opportunity to testify on what can be done through federal tax policy to help small businesses. My name is Curtis Dubay. I am tax economist at The Heritage Foundation, a non-profit research organization based in Washington with over 650,000 members nationally and growing rapidly. The views I express in this testimony are my own, and should not be construed as representing any official position of The Heritage Foundation.

Many small businesses are struggling to survive as economic recovery remains slow. The primary focus of economic policy should be to improve the health of the overall economy. There is much the federal government can do in this regard, and mostly it involves allowing the recovery to continue without the threat of punitive new taxes and burdensome new regulations. Reducing the budget deficit solely through spending reductions would also benefit the overall economy by reducing the threat of a sovereign debt crisis here in the U.S. such as is now underway in Greece and threatening Portugal, Spain, and other countries. Eliminate these threats and small businesses will then thrive as the recovery quickens its pace.

There are far more types of small businesses engaged in more kinds of economic activity than Congress can devise special tax benefits to help. This sort of one-off, micro-managing, tinkering policy may gain a headline and support, but it will not help small businesses broadly. What they need first and foremost is lower tax rates. Therefore, it would be irresponsible for Congress to raise their tax rates now, but that is just what Congress is planning to do.

On January 1, 2011, the tax rates facing small businesses are set to jump, destroying jobs and lowering wages. The top two income tax rates now stand at 33 percent and 35 percent, but will rise to 36 percent and 39.6 percent. These increases will hit small businesses hard. A widely propagated myth contends that raising top tax rates has little effect on small businesses because only a small percentage of them pay rates at that level. But the number of businesses that pay top rates is economically meaningless because so many small businesses represent the part-time efforts of their owners. An economically meaningful measure shows that raising top income tax rates would slam the small businesses that contribute the most to our economy.

According to the Treasury Department and as shown in the chart below, 8 percent of small businesses pay the highest two tax rates. But those businesses earn 72 percent of all small business income and pay 82 percent of all income taxes paid by small businesses.[1]

Higher tax rates on the rich would hit the bulk of small business economy

The small businesses that will pay higher taxes earn an overwhelming majority of small business income and employ most of the workers hired by small businesses. It is these businesses that the economy needs to create new jobs and ramp up economic growth after the severe recession. Higher tax rates would drain the businesses of cash flow, the lifeblood of any business, and would diminish the incentives to grow and add new workers.

Raising rates on these successful businesses would damage the economy at any time, but doing so now when the unemployment rate is starkly elevated and the recovery just underway is stunningly foolish.

Instead, at the very least President Obama and Congress should drop their plans to increase top tax rates on small businesses and make permanent the current-law tax rates for all taxpayers. This would eliminate yet another threat facing small businesses seeking to survive in some cases, in others to expand and add new jobs. This would be the best stimulus for the economy to date.

Lower Taxes on Capital Would Help Small Businesses

In addition to higher income tax rates, Congress is threatening to raise taxes on productive capital for small businesses. Capital is any resource that individuals or businesses use to create a good or provide a service. Like anything else, when the income accruing to capital is taxed, its user price rises and less of it is purchased. That means small businesses have less productive capability, grow slower, and pay lower wages. As such, taxes on capital should be minimal or nonexistent.

The current tax code taxes capital heavily. It taxes capital through the capital gains tax and taxes on dividends, both at 15 percent, and through taxes on business income and the corporate income tax—especially because businesses cannot deduct the full cost of the capital they buy, but must depreciate it over several years at a lower real value.

Under current law, the tax rate on capital gains will increase to 20 percent and that on dividends will increase to up to 39.6 percent on January 1, 2011. Congress should at the very least hold these rates at 15 percent. To lower the cost of capital for small businesses further, Congress should consider lowering the rate on capital gains and dividends below 15 percent and make permanent President Obama’s plan to provide immediate small business expensing of all capital purchases.

Targeted Tax Cuts No Substitute for Low Rates

Many in Congress would prefer to offer targeted tax credits to specific small businesses instead of keeping income tax rates and taxes on capital low for all small businesses. But targeted tax cuts are no substitute. Targeted tax credits for small businesses that produce or sell certain items do not stimulate the economy or assist small businesses in general. They are corporate welfare for certain businesses that produce and sell goods that Congress deems beneficial.

When Congress provides tax breaks for only certain businesses it is picking economic winners and losers instead of allowing the marketplace—the traditional and wiser decision maker in such matters—to decide. It does so because the targeted tax credits give their recipients an advantage in the market compared to the businesses not fortunate enough to receive the tax break. The businesses that get the credit can keep their prices lower than they otherwise would without the credit.

Furthermore, in the current budgetary environment, since targeted tax cuts would be financed by adding to the deficit instead of reducing spending, the increased borrowing would take available funds away from other businesses. These other businesses could have used the funds to expand operations and add new jobs, but Congress will divert the resources to the businesses it prefers.

Congress should not be the arbiter of which businesses succeed and which do not. Its track record of making such choices is far from exemplary, and further efforts to move the market in the direction it desires could actually prevent breakthroughs that would benefit the economy and the United States.

The economy will recover eventually, and when it does the sales and profitability of small businesses will improve. At that time, targeted tax incentives will do nothing for the vast majority of small businesses that are ineligible to claim the tax breaks. For these businesses, and the economy as a whole, it is better to have low tax rates. That way, Congress is not influencing economic outcomes or engaging in corporate welfare, and small businesses have the proper incentives to expand operations, create jobs, and increase wages.

Resurrection of Death Tax Major Issue for Small Businesses

In addition to higher tax rates, small businesses may face higher death tax bills in the near future. The death tax expired for one year, beginning on January 1, 2010, and returns in full force on January 1, 2011. The death tax is a drag on America’s small businesses, destroys jobs, and lowers wages while raising little revenue. As such, Congress should repeal the estate tax once and for all to remove an unfair burden from the backs of American small businesses and their workers.

When Congress passed the death tax in its modern form in 1916, it was supposed to prevent the buildup of wealth in a concentrated number of families and be a new source of revenue.[2] But in today’s modern global market, the well-off are more likely to accumulate wealth by creating new and innovative products demanded by the expanding global market than through inheritance.

For instance, of the Americans in the top 25 of the Forbes list of billionaires, only those in the Walton family (Wal-Mart) inherited their fortunes.[3] The rest—including Bill Gates (no. 1), Warren Buffett (no. 2), Lawrence Ellison (no. 4), Michael Bloomberg (no. 17), and Michael Dell (no. 25)—earned their fortunes by taking risks and through innovation, business acumen, and hard work. Because wealth creation is so widespread, and not restricted to family lines or a lucky few that hit it big, the estate tax is largely irrelevant to ensuring a more equal distribution of wealth—assuming that was a defensible policy goal.

Despite the common misconception that the death tax impacts only wealthy estates, economists now generally agree that it is actually a tax on capital because of its impact on businesses and workers.[4] Capital—whether it is cash, equipment, or other types of property—is necessary for businesses to create new jobs and pay higher wages. There is a general consensus among economists that taxing capital is harmful to the economy.[5]

A recent study found that a full repeal of the death tax would create 1.5 million jobs.[6] This is half the number of jobs President Obama claimed the $800 billion stimulus package would create—at one-fifth the price.

Additional benefits from full repeal of the death tax include:

  • Increasing small business capital by over $1.6 trillion;
  • Increasing the probability of hiring by 8.6 percent;
  • Increasing payrolls by 2.6 percent;
  • Expanding investment by 3 percent; and
  • Slashing the current jobless rate by 0.9 percent.

The death tax also impedes economic growth because it stands opposed to the principles of virtue, thrift, and savings that made America the strongest nation on earth. For those Americans who think that their estates may one day pay federal death taxes, the death tax increases their incentive to consume their wealth today rather than invest and make more money in the future. Instead of putting their money in the hands of entrepreneurs or investing more in their own economic endeavors, Americans get the unmistakable message to consume it now.[7]

It is time for Congress to kill the death tax once and for all. Doing so would lift a tremendous weight off the shoulders of America’s small businesses, create jobs for out-of-work Americans, and help the ailing economy.

Health Care Bill Adds New Burden on Small Businesses

Small businesses are not only dealing with potential damaging tax hikes, but now that President Obama has signed into law the Patient Protection and Affordable Care Act (PPACA) of 2010, small businesses can expect substantial tax increases in the near future. Combined, all of the tax increases in the PPACA (including those on employers that do not provide health insurance for their employees and on individuals who do not buy health insurance) will cost taxpayers $503 billion between 2010 and 2019.[8] Small businesses, their customers, and their workers will pay many of these higher taxes.

These tax hikes will slow economic growth, reduce employment, and suppress wages. By delaying the effective date for most of these new taxes, the President and Congress have shown themselves unwilling to implement these taxes on their own watch, raising doubts as to whether future Presidents and Congresses will be willing to do so. This increases even further the likelihood that this bill will substantially increase the deficit, which would break another Obama promise.

the List of the Obamacare Taxes

Bureaucratic Burden hurts Small Businesses

A little noticed provision added to the PPACA will burden small businesses with new paperwork:

Under current law, businesses are required to issue 1099s in a limited set of situations, such as when paying outside consultants. The health care bill includes a vast expansion in this information reporting requirement. Businesses will now have to issue 1099s whenever they do more than $600 of business with another entity.[9]

Small businesses will now have to issue possibly billions of new forms to the IRS. While large businesses can absorb the cost of this new bureaucracy with their large legal and accounting teams, the new requirements will slam small businesses hard. The paperwork burden will force small businesses to redirect scarce resources from productive activities that could grow the business, add jobs, and pay higher wages to complying with the onerous new reporting requirements.

Tax Extenders Excuse to Raise Taxes Each Year

Each year about 45 tax provisions, collectively known as the “tax extenders,” expire. These tax provisions, which apply to both individuals and businesses, include popular measures such as the research-and-development credit. Each year Congress must extend these laws to avoid tax increases on small businesses, hence their name “tax extenders.”

Congress retains the tax extenders annually—but not before much hand-wringing about their supposed cost and even more haggling about paying for them with increases in other taxes. Congress should remember that continuing the tax extenders for another year is not a tax cut and that there is no need to pay for them with tax hikes.[10]

Congress should permanently extend all the expiring provisions it deems good tax policy and let the others expire. Congress should avoid any net tax hike, however, so for those provisions that it allows to expire, it should cut other taxes. Lowering marginal income tax rates would be the best course, since that would help spur the still-struggling economy[11] and it would directly help small business. The yearly threat of a tax hike ties the hands of many small businesses and holds them back from making important business decisions. A permanent extension of the tax extenders would provide stability for small businesses to plan for the future.

About the Author

Curtis S. Dubay Research Fellow, Tax and Economic Policy
Thomas A. Roe Institute for Economic Policy Studies

Show references in this report

[1] U.S. Department of Treasury, “Treasury Conference on Business Taxation and Global Competitiveness,” July 23, 2007, p. 18, at /static/reportimages/E38CC2897AF3ECA865B6BF89138319B7.pdf (May 3, 2010).

[2] See Darien B. Jacobson, Brian G. Raub, and Barry W. Johnson, “The Estate Tax: Ninety Years and Counting,” SOI Bulletin, Summer 2007, p. 120, at http://www.irs.gov/pub/irs-soi/ninetyestate.pdf (November 6, 2009).

[3] Forbes, “The World's Billionaires,” March 11, 2009, at http://www.forbes.com/lists/2009/10/billionaires-2009-richest-people_The-Worlds-Billionaires_Rank.html (November 6, 2009).

[4] See Robert Carroll et al., “Personal Income Taxes and the Growth of Small Firms,” National Bureau of Economic Research, October 2000, at http://www.nber.org/papers/w7980 (November 9, 2009).

[5] See Kenneth L. Judd, “The Optimal Tax Rate for Capital Income Is Negative,” National Bureau of Economic Research, April 1997, at http://www.nber.org/tmp/87514-w6004.pdf (November 12, 2009).

[6] Douglas Holtz-Eakin and Cameron T. Smith, “Changing Views of the Estate Tax: Implications for Legislative Options,” American Family Business Institute, February 2009, at http://www.nodeathtax.org/files/AFBF_Holtz_Eakin_2009.pdf (November 6, 2009).

[7] William W. Beach, “Seven Reasons Why Congress Should Repeal, Not Fix, the Death Tax,” Heritage Foundation WebMemo No. 2688, November 9, 2009, at http://www.heritage.org/Research/Taxes/wm2688.cfm.

[8] Joint Committee on Taxation, “Estimated Revenue Effects of the Amendment in the Nature of a Substitute to H.R. 4872, the ‘Reconciliation Act of 2010,’ as Amended, in Combination with the Revenue Effects of H.R. 3590, the ‘Patient Protection and Affordable Care Act (“PPACA”),’ as Passed by the Senate, and Scheduled for Consideration by the House Committee on Rules on March 20, 2010,” March 20, 2010, at http://www.jct.gov/publications.html?func=startdown&id=3672 (April 5, 2010); Congressional Budget Office, Letter from Douglas W. Elmendorf, Director, to the Honorable Nancy Pelosi, Speaker, U.S. House of Representatives, March 20, 2010, at http://www.cbo.gov/ftpdocs/113xx/doc11379/Manager'sAmendmenttoReconciliationProposal.pdf (April 5, 2010).

[9] Chris Edwards, “Costly IRS Mandate Slipped into Health Bill,” Cato at Liberty, April 26, 2010, at http://www.cato-at-liberty.org/2010/04/26/costly-irs-mandate-slipped-into-health-bill/ (May 3, 2010).

[10] J. D. Foster and Stephen A. Keen, “Senate Tax Extenders: Another Sneaky Tax Hike,” Heritage Foundation WebMemo No. 2006, July 30, 2008, at http://www.heritage.org/Research/Taxes/wm2006.cfm.

[11] J. D. Foster and William W. Beach, “Economic Recovery: How Best to End the Recession,” Heritage Foundation WebMemo No. 2191, January 7, 2009, at http://www.heritage.org/Research/Economy/wm2191.cfm.