Understanding Just How Harmful Obama’s Tax Hikes Would Be

By Scott Shane

The massive U.S. fiscal deficit has prompted the Obama administration to consider raising taxes on small business owners. Let us count the ways this is a mistake.

In his 2012 budget, President Obama proposes reforming the tax system to help reduce the country’s fiscal deficit. Unfortunately for many small business owners, these reforms include tax hikes on them.

Among the tax increases that would hit small company owners proposed in the president’s budget are a higher marginal tax rate on income from sole proprietorships, Subchapter S corporations, and other pass-through entities; increased capital gains taxes on investments by high earners; repeal of the last-in-first-out approach to inventory accounting (LIFO); and treatment of private equity and venture capital carried interest as ordinary income.

While raising taxes on small business might help to reduce the deficit–so long as we do not just increase government spending at the same time–it decreases small business starts, growth, hiring, and investment, making it a bad economic move.

Progressive income taxes discourage business formation because they penalize people for successful risk taking but do not compensate them when they fail at the same activity. Research by Glenn Hubbard and William Gentry shows that higher marginal tax rates lead to lower rates of company formation, while analysis by the World Bank and Donald Bruce and Tami Gurley-Calvez shows a negative correlation between tax rates and new business formation.

Raising taxes on small business decreases small business starts, growth, hiring, and investment–making it a bad economic move.

High tax rates reduce owners’ incentives to expand their businesses. Research by David Bruce shows that higher taxes increase the likelihood that small business owners will shutter their companies. And analysis by Robert Carroll and co-authors reveals that a 10 percent drop in small business owners’ after-tax income is associated with a decrease of 8 percent in businesses’ revenues.

Additionally, high taxes stymie small business hiring and capital investment. A study by Carroll and co-authors reveals that slicing 10 percent off small business owners’ after tax income lowers their probability of hiring additional workers by 12 percent and shaves 4 percent off the wages they pay their typical workers. Another study by Carroll and colleagues shows that boosting entrepreneurs’ tax rates by 5 percent leads them to cut capital investment by 10 percent.

Research also shows that the specific tax increases proposed by the president in his 2012 budget would adversely affect small business owners. As Mark Zandi of Moody Analytics explains, the hike in marginal tax rates would fall heavily on small business because small business owners make up one-third of the tax payers in the highest marginal brackets.

While Americans may be in favor of soaking the rich, they do not like raising taxes on small business owners, who are seen as the embodiment of the American Dream.

Moreover, analysis by the House and Senate Joint Committee on Taxation shows that half of net-positive business income goes to tax payers hit by the top marginal tax rates.

The president’s proposal to end LIFO would also be problematic for small company owners. The Small Business Administration told the president’s Economic Recovery Advisory Board that “eliminating the ability to use LIFO would result in a tax increase for small business that could ultimately force many small businesses to close.”

The president’s proposal to increase capital gains taxes will also adversely affect entrepreneurial activity. Analysis by Christian Keuschnigg and Soren Bo Nielsen indicates that “even a small capital gains tax … diminishes incentives to provide entrepreneurial effort.” This is problematic for entrepreneurs, whose effort is needed to build businesses.

Moreover, small businesses pay a high cost for capital, which can be offset by lower capital gains tax rates. But when capital gains taxes go up, investors who provide risk capital to entrepreneurs have an incentive to put their money into tax-free bonds rather than into financing growth-oriented entrepreneurs.

Higher marginal tax rates lead to lower rates of company formation.

Raising taxes on small business owners is not even a good political move. While Americans may be in favor of soaking the rich, as recent polls indicate, they do not like raising taxes on small business owners, who are seen as the embodiment of the American Dream.

Moreover, small business owners are a major chunk of the electorate. Applying IRS data on the number of businesses to Federal Reserve data on the number of small businesses owners yields more than 60 million people, about half the number who voted in the last presidential election.

The massive U.S. fiscal deficit has prompted the Obama administration to consider raising taxes on small business owners. However, research shows that such a move would be an economic mistake. While I hold out little hope for the White House to recognize the economic arguments here, perhaps the president, with his political antennae out for a 2012 reelection bid, will realize the political folly of such a move.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.