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Tax Planning

Tax Hikes for Small Business?

Would higher taxes for upper incomers put a damper on small business?

Between now and Dec. 31, Congress will make a huge decision -- which, if any, of the 2001 and 2003 Bush tax cuts should be extended, and for how long. The outcome will affect the family budgets of almost every American. It will also have a big effect on the U.S. budget deficit and the debt we leave to our grandchildren. And last, but certainly not least, it will affect the economy, either slowing or spurring growth.

Senator Majority Leader Harry Reid (D-Nev.) wants to have this debate in September, which means it will become even more of a political football than it already is. Republicans want to make the Bush tax cuts permanent for everyone. President Obama and most Democrats want to extend them only for individuals making up to $200,000 a year and couples making up to $250,000.

Who would that affect and how? The 3.8 million filers who earn between $200,000 and $500,000 would pay an average of $532 more in taxes, according to an analysis by the Joint Committee on Taxation. The 608,000 who make between $500,000 and $1 million would pay an average of $10,000 more. Those who make more than a million would pay about $100,000 more on average. Keep in mind that even the richest taxpayers would benefit from an extension of the lower rates for others because the rates apply to the first $200,000 in income no matter the total.

Democrats use those numbers to accuse Republicans of doing what they always want to do -- protect the rich. Republicans accuse Democrats of using them to support what they always want to do -- raise taxes.


And at the center of debate will be small businesses, many of which report their income on the 1040, using Schedule C (self-employeds and sole proprietors), Schedule E (S corporations) or Schedule F (farmers). As a result, owners of these enterprises are subject to the same tax rates as wage earners.

Sen. Orrin Hatch (R-Utah) calls the Democratic plan a “job-killing tax hike on small business.” Senate Minority Leader Mitch McConnell (R-Ky.) has repeatedly claimed that the tax hike would affect half the small businesses in the U.S.

That’s patently false. Letting all the tax cuts expire would affect half of small business income, but no one is seriously proposing that. The Tax Policy Center has calculated that only 2.5% of those reporting business income on their 1040s go over the $200,000/$250,000 limits and would therefore be affected. And many of the people in those top brackets do not rely on small business income and aren’t about to create new jobs, no matter the tax rate. Many have full-time positions, for example, but earn some independent income writing, speaking or consulting. Many are lawyers or doctors in partnerships.

The Cato Institute’s Daniel J. Mitchell argues that all these numbers are beside the point. A tax hike on the rich, no matter how they make their money, would mean less investment in small businesses and less capital to grow, he says. Many others agree with that.


Others insist that increasing the deficit by $680 billion over 10 years, which is what the high-end tax break would do, would also have an impact on credit markets. The more the government keeps borrowing, the less that’s available for businesses. Daniels says that’s misleading because most of the debt is financed from overseas, and anyway, U.S. companies are sitting on mountains of cash they could lend.

In fact, capital doesn’t seem to be what’s holding businesses back from hiring. It’s confidence in the economy. And tax incentives are unlikely to change that. The Hudson Institute has a fascinating study examining the whole issue, including the theory that higher rates actually encourage small business formation because they allow owners to shelter more income.

This is a complicated issue -- one that deserves careful debate, not political grandstanding, false claims and statistics that lie. Reid’s decision to hold the debate before the election is almost guaranteed to fail, increasing the odds of a one-year extension of all the cuts. That just puts off the decision and creates more uncertainty for everyone. It also raises the odds that the two sides will play a game of chicken that we all will lose. If Congress truly deadlocks and does nothing -- all rates will increase, and no one thinks that is a good idea.