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Just what effect would tax hike on top earners have on small business?

Tax Facts

Small businesses and small children have just one thing in common: A politician would have to be crazy to even hint at hurting them in any way.

Small business owners are "poster children," if you will, in arguments against raising taxes on top income earners. That argument has all but paralyzed Congress in its decision over how far to extend the Bush tax cuts. In Minnesota, it marks a clear divide in the race for governor and in some races for Congress and the Legislature.

The arguments revolve around these claims: 1) Small businesses are the major generators of new jobs. 2) A hefty share of these job generators are taxed through the individual income tax. 3) Therefore, a tax increase on top earners stifles job creation.

The points in this debate are not at all easy to dissect. So I should say up front that this article will not provide clear-cut, yes-or-no answers. There are no such answers.


That reality alone tells us something about the claims coming from politicians across the political spectrum. Typically they are stated with more certainty than the facts can support.

How small?
Let's begin this final installment of MinnPost's tax series by asking what constitutes a small business.

Most businesses with fewer than 500 employees are counted as "small" by the Small Business Administration [PDF]. By that definition, Minnesota had nearly 500,000 small businesses in 2007.

Indeed, if the 500-employee standard were the sole definition, the vast majority of Minnesota businesses would be considered small. They could include prestigious downtown law firms such as Gray Plant Mooty, which has operated in the region for more than a century. And they could include Dandelion Kitchen, one of the new street-food vendors licensed to operate in Minneapolis this year.


What percentage of Minnesota filers would feel the bite of an added tax bracket on top earners?

  Tax bracket starts at taxable income of
  $250,000 married filing jointly or $141,000 single filers $200,000 married filing jointly or $113,200 single filers $150,000 married filing jointly or $130,000 single filers
Returns reporting positive net income from business 4.9% 6.4% 8.7%
All returns 2.4% 3.4%  4.7%
Source: Minnesota Department of Revenue

Both are important to the local economy. Clearly, though, they are very different in terms of fitting the commonly held notion of the struggling small business.

The ambiguities grow when you ask how many of those 500,000 small Minnesota businesses actually create jobs. The Minnesota Department of Revenue says that 377,000 of those businesses had no employees. So they can't be the job-generators we're worried about.

That leaves about 122,000 "small" employers in the state. The fact remains, though, that many of those firms have hundreds of employees.

Most of us could agree that they hardly define the mom-and-pop startups that come to mind when politicians talk about protecting small businesses. Thus, analysts often consider other factors — say, an annual payroll of $5 million or less — in deciding which businesses truly are small.

Mind the definitions
So definitions make a big difference in this debate. And politicians often will draw upon the definitions that support the points they want to make.

Sen. Mitch McConnell
REUTERS/Jim Young
Sen. Mitch McConnell

For example, Republican Senate Minority Leader Mitch McConnell of Kentucky said recently on NBC's "Meet the Press" that in the last quarter of 2009, "84 percent of the jobs that were lost were lost in small businesses."

Factcheck.org points out that McConnell's figure is based on Bureau of Labor Statistics data for firms with up to 499 employees.

"Viewers may not have been aware that the 'small businesses' McConnell referred to employ a little more than half of all private sector workers," said FactCheck, which is a project of the Annenberg Public Policy Center at the University of Pennsylvania.

Who feels the bite?
Under any definition, there is no perfect way to sort small business owners from other taxpayers.

One approach is to consider filers who report "flow-through" business income — in other words, those who treat income from a business as personal income for tax purposes. Typically, these folks are reporting income from a partnership, a sole proprietorship, a farm or a so-called S Corporation (for which income is taxed at the shareholder level, not the corporate level.)

Minnesota had some 542,000 flow-through filers in 2007, the state revenue department said.

Roughly 47,000 of those filers would have paid more taxes if a higher bracket were imposed on taxable incomes over $150,000 for married couples filing jointly and $130,000 for single filers (DFL gubernatorial candidate Mark Dayton's plan.)

That's about 8.7 percent of the flow-through filers. And it's a significant portion given that overall, just 4.7 Minnesotans would feel the bite of such a tax hike.

In other words, you could conclude that the tax on top earners will weigh heavier on these flow-through business owners.

Some are very large
Here's the rub: The revenue department doesn't know the size of those businesses. Some flow-throughs are "very large," it said in response to my request for this data.

And some taxpayers who report flow-through income also get earnings from other sources — say, a doctor who invests in a real-estate deal on the side but draws the bulk of her earnings from a big hospital. Only about 30 percent of the total adjusted gross income of those who would feel the bite of the new bracket is net flow-through business income, the revenue department said.

Analysts at the Minnesota Budget Project — an initiative of the Minnesota Council of Nonprofits — summed up the situation this way:

"The universe of households with some flow-through income goes well beyond those people who run a small family business, such as a restaurant, hardware store or barbershop. They also include doctors, lawyers and other professionals who have structured their businesses as S-corps or partnerships, as well as those who are passive investors in small businesses. The flow-through income on any individual return could be only a small part of that household's total income."

Further, it noted that small businesses are allowed deductions to offset the costs of running their businesses. The portion leftover is individual income, the budget project said, and that should be taxed in the same way as salaried income.

Some other analysts, though, stress that even a small tax hike on small business owners could cost jobs that sorely are needed right now.

Mark Zandi
Mark Zandi

Successful small-business owners, who power the nation's job-creation machinery, make up one-third of the taxpayers nationwide who would suffer if the Bush tax cuts were allowed to expire for the wealthy, Mark Zandi, chief economist for Moody's Analytical, wrote in an opinion piece for the New York Times.

"They have set up their businesses so that their profits are taxed at personal rates," Zandi said. "Raising marginal tax rates, even a little, on those who have suffered during the past several years would be a mistake."

Complexity grows
You get an idea of the difficulty in supporting or refuting claims about small businesses and personal income taxes.

It gets even worse.

Economists can't agree on our central assumption: that small businesses truly are the engine of job growth, says a report in the latest issue of "The Region," a publication of the Federal Reserve Bank of Minneapolis.

Phil Davies
Phil Davies

"Economists have sharply debated the issue for 30 years," says the report by senior writer Phil Davies. "Some investigators conclude that small firms do indeed punch above their weight class in generating job gains. Others, looking at similar data, find scant evidence to support this conventional wisdom."

Age and innovation trump size
There are good reasons to argue that the age of a firm and its level of innovation are more relevant to job growth than the size.

Working from a garage in Menlo Park, Google's two founders hired their first employee in 1998. Today some 20,000 people worldwide work for Google.

Earl Bakken and his brother-in-law founded Medtronic as a small medical equipment repair shop in Minneapolis in 1949. This year the company reported a global workforce of nearly 40,000.

It wasn't size alone that empowered those companies to hire and grow. It was innovation, the fact that they offered something new and useful. And because they continued to innovate, they continued to hire even after they crossed any line you choose to define big-business territory.

Recent analysis of 13 years of census data found no systematic link between net growth rates and firm size, said the report from the Minneapolis fed.

"But the contribution of firms less than 10 years old, particularly startups, to job creation was substantial," it said.

Many new businesses fail, destroying jobs in the process. Those that survive and expand are the true engines of job growth.

For now, the fed report concluded "the conventional wisdom that small businesses are the primary source of job creation remains a matter for continuing debate."

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Comments (15)

Great reporting. Congrats. How about demand as a contributor to job growth?

It seems to me the reason finding an answer to this question is so difficult is that it is the wrong question. How much tax should a certain class of individual pay is a political question, not an economic one, even though the answer has economic effects.

I think trying to answer the question "why do some politicians advance this argument (that taxing high earners threatens jobs)" would yield more valuable results.

Whether or not the argument is valid, one stripe of politician makes it. Why?

Thanks for clearing that up.

Sharon
Fine article and much needed.

So...let me answer the question you ask: "what effect would a tax hike have on small business"?

Having been a small business in Minnesota FOR OVER 50 YEARS, I can answer with some authority and experience. My answer, as to the effect it would have had on me, my strategy for growth and years of success is.......

None!

In short, the argument is bogus.

Small business income covers many things: income from limited partnerships (real estate, oil and gas or a chain of fast-food franchises); earnings from professional corporations for doctors, dentists and lawyers; income from trusts; rental income from vacation homes and commercial real estate. These aren't necessarily family businesses or risk-taking entrepreneurs. A lof of these taxpayers are simply high-income professionals or very wealthy people who earn streams of income from many different investments. There's nothing wrong with those people, but nothing particularly sacred about them either.

Don't you simply need to separate gross from net income? If I have a small business and I gross $400,000 in some year, and spend $300,000 on employee salaries, then my $100,000 take-home is less than the "high tax" bracket. If I simply keep all of the $400,000, then it should be taxed in the high bracket. I guess I'm just having trouble understanding why this is a problem.

Excellent reporting Sharon. A long journey from your days as a News Assistant on the old Star!

I think I would also be defined as a "small business". In retirement, I have a little side venture of consulting (which brings in a few bucks each year) against which I deduct certain business operating expenses. What's left over "goes to the bottom line" on my tax form (as taxable income) and is taxed at whatever rate that number puts me at each year. In no way would me paying a higher rate on that taxable income (if I were lucky enough to get over that bar in a given year) impact in any way the hiring of any employees, as I have none and expect none.

I particularly liked this phrase in your article:

"That reality alone tells us something about the claims coming from politicians across the political spectrum. Typically they are stated with more certainty than the facts can support."

Personally, I mute and/or fast-forward through every political commercial on TV, but one still sees the printed "claims" displayed on the screen. Most (from both sides) are so outrageous as to almost be humorous. I think we need somebody to make a documentary movie highlighting how much nonsense is in these ads.

Keep up the good work Sharon!

"They have set up their businesses so that their profits are taxed at personal rates," Zandi said.

Exactly. The business owners chose how they wanted their business income taxed — a choice not available to wage earners.

Last year, Growth & Justice did a study estimating the impact of a new top-tier income tax. http://www.growthandjustice.org/Media_By_fourth_tier.html

It found the proposed increase would result in higher taxes for 60,400 filers — 2.6 percent of all Minnesota taxpayers. About half that group derived at least some income from ownership in a small business.

On average, each affected taxpayer would pay a net additional $1,406 after deducting state taxes on their federal returns.

The real question is effect on the economy. We have a new policy paper and a forthcoming op/ed on the subject.

Note that the innovators at Google and Medtronic both started their companies in states considered to be high-tax, their companies and payrolls grew in high-tax states and their companies are still headquartered in high-tax states. Taxes, it would appear, did not stifle growth at these companies or cause the companies to flee to low- or no-tax states.

Further, high-tax states typically invest more in education, infrastructure and health making them attractive places for businesses to locate and grow.

Sharon, I would also suggest that to assess this issue one needs to compare small business job creation with large business job creation. I have seen evidence that large businesses in fact create more jobs--sorry, wish I could provide a link to the story; I think it was in the Washington Post.

"The Minnesota Department of Revenue says that 377,000 of those businesses had no employees. So they can't be the job-generators we're worried about."

Unless those 377,000 businesses are owned and operated by robots, they've generated at least 377,000 jobs.

Actually one problem that doesn't seem to be addressed here is whether or not a tax hike for these people would actually harm or help them. There seems to be this assumption that a tax hike necessarily has a negative effect, the only question is how negative. In fact tax hikes can have no effect, or even a positive effect under some circumstances depending the services that are financed with additional taxes. At any it's clear that simplistic "taxes kill jobs" big government arguments are incoherent.

What I take from this article is that in order to create a "better EMPLOYMENT climate" in Minnesota

--(which is what the phrase "better business climate" seems to promise but NEVER delivers, delivering instead, higher incomes and tax breaks for the already fabulously wealthy)--

what we most need is good, solid support in terms of helpful financing for, health care for, and, perhaps, tax breaks for, startup businesses, especially high tech startups.

The Chamber of Commerce, being a business cartel, would object to the possibility of new competition, but I don't believe the public has any responsibility to worry about that problem. As this year's election cycle is proving, the big money, Chamber of Commerce types seem well able to take care of their own interests.

It is the purpose of the state to act to serve the interests of ALL of us.

Excellent and interesting reporting.

My beef is, it's all about the cost of government, and how that cost hits taxpayers.

But we are also receivers of government services. I'd rather pay a bit more in taxes, if it avoids the $400 repair job i had on my Toyota when a tire hit a pothole so deep it damaged the wheel.

I'd rather pay a bit more in taxes so that nurses in public hospitals are staffed to levels where they are not exhausted, more likely to make medical mistakes.

More generally, it's not just about the cost of government. When "small" businesses need services, they contract with other small businesses rather than add employees - those other businesses exist in a nexus of business activity .... and those are hard to maintain in places where government services are inferior, starting with educational quality.

How much will small business operators be hurt if a more conservative agenda, in an effort reign in taxes .... decreases investment in education and infrastructure, parks and prisons?

Great article, on the best news web site around

Myles Spicer (#4) and Jeff Klein (#6) both see the falsity of the right-wing claim that a tax cut on higher-income earners would hurt small businesses. That claim would be true only if a business's GROSS receipts were considered the personal, taxable income of its owner.

The personal, taxable income of its owner is what remains after all expenditures for business expenses (payroll, taxes, raw materials, investment in new technology or facilities, advertising/marketing, et cetera) are paid.

Sharon Schmickle certainly defined the variables on taxes etc, in a small business environment.

I could say, I expect no less from S.S....always does a well researched coverage...which qualifies as one much needed education on the subject, for this reader.

And some of the 'comments' weren't too shabby either, hey. Thanks.