Taxes and Small Business Job Creation

CATO INSTITUTE:

STATEMENT of

Chris Edwards,
Director of Tax Policy Studies, Cato Institute, Washington, DC

before the

SCommittee on Finance
United States Senate
Taxes and Small Business Job Creation

February 23, 2010

Mr. Chairman and members of the committee, thank you for inviting me to testify today on taxes and small business job creation.

Numerous provisions affect the tax climate for small businesses, including payroll taxes, capital gains taxes, and the treatment of capital investment. But I will focus on marginal income tax rates because that's where there seems to be the most disagreement and uncertainly about the future direction of tax policy. The Obama administration has proposed increasing the top two individual income tax rates, but that policy would likely have a negative impact on U.S. economic growth.

The administration has offered some narrow and temporary tax breaks for small business job creation, but that is not a promising approach for tax policy. Instead, Congress should focus on creating a simple, neutral, and pro-growth tax structure for all American businesses, large and small. After all, there is no strict separation of large and small businesses in the tax code. Many businesses that report their profits on individual returns are medium and larger businesses.

New jobs are created by fast-growing businesses, whether small or large. A new job at a multinational computer chip maker is certainly as valuable as a new job at the corner restaurant, and probably more durable. Thus, while my remarks focus on tax policies for smaller businesses, large C corporations are also crucial to U.S. economic growth. Policymakers should consider reforms to reduce statutory tax rates on both corporate and noncorporate businesses.1

Responses to High Marginal Tax Rates

The Obama administration is proposing to raise the top two individual income tax rates from 33 and 35 percent to 36 and 39.6 percent, respectively, in 2011. That would likely harm investment, job creation, and growth. Higher marginal tax rates reduce incentives for productive activities, such as working and expanding businesses, and they increase incentives for unproductive activities, such as tax avoidance and evasion.

If income tax rates rise next year, we may not perceive large negative effects right away, but changes in marginal tax rates do affect behavior over the long term. Some high-income workers would decide to work fewer hours and retire a bit earlier. Some spouses in two-earner families would decide to stay out of the workforce. Some angel investors would have less cash to invest in start-up ventures. And some small businesses would decide not to buy new equipment or hire new workers.

How large are the behavioral responses to marginal income tax rate changes? Many empirical studies have found that reported income is quite responsive to the top income tax rates. In a 2009 paper, for example, economists Emmanuel Saez, Joel Slemrod, and Seth Giertz noted that the share of income "received by the top 1 percent of income recipients started to increase precisely after 1981 when marginal tax rates started to decline. The timing of the jump in the share of top incomes from 1986 to 1988 corresponds exactly to the sharp drop in the weighted average marginal tax rates from 45 percent to 29 percent after the Tax Reform Act of 1986. [This] provides circumstantial but quite compelling evidence that high incomes are indeed responsive to marginal tax rates."2

A typical finding is that a tax rate increase that reduces the after-tax share on additional income by 10 percent results in shrinking reported income by about 4 percent.3 For higher earners, empirical studies usually find substantially larger behavioral responses.4 That's because higher-income taxpayers typically have more flexibility on their working decisions and they have greater shares of financial and business income, which are more responsive and mobile than labor income.

A side-effect of these behavioral responses is that governments raise less money than they expect from tax rate increases, particularly at the top end. If Congress raised the top income tax rate from 35 to 39.6 percent, the government would gain 4.6 percentage points on the money in the top bracket. But reported income would fall modestly, and that fall would offset a substantial portion of the revenue gain. In a recent paper, economist Robert Carroll summarized Treasury estimates that modeled changes in the top two income tax rates.5 The results suggest that raising the top two rates would cause reported income of affected taxpayers to fall three percent, which would be enough to offset about 40 percent of the expected static revenue gain.

When considering raising tax rates at the top end, Congress needs to think carefully about who would be hit. Today's highest-earners are generally not passive inheritors of wealth, but are usually self-made and entrepreneurial.6 Business ownership and current earnings are the main sources of wealth for the richest individuals, while inheritances account for less than one-fifth of the assets of the richest people and that share has been declining.7 As economist Glenn Hubbard noted, "when you look at data, you see that people who are rich almost entirely are rich because of entrepreneurial risk taking,"8

Many with high incomes are angel investors, who help to fuel small business expansion. There are at least 300,000 angel investors in the United States, who are often wealthy individuals and have been entrepreneurs themselves.9 They provide an important source of financing for fast-growing small businesses. If their taxes go up, they will have less money and fewer incentives to invest, while perhaps parking more of their funds in tax-free municipal bonds.

In sum, trying to raise revenue by increasing the top income tax rates is a perverse budget strategy. It would hit some of the most talented people in the economy. Since high earners generally have the largest behavioral responses to taxes, the deadweight losses (or costs of inefficiency) of such tax changes would be quite large.10 And since deadweight losses rise more than proportionally as marginal tax rates rise, raising the top rates would be very counterproductive.11

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