Thursday, December 2, 2010

Bush Tax Cuts and Small Business

I have been requested to comment on GOP claims that the expiration of the Bush tax cuts will harm small businesses and the jobs that they create. First lets examine what happens if the Bush tax cuts expire and then consider the implications for small businesses and jobs. Then we will look at the real reason why the GOP wants to extend the Bush tax cuts.

If the Bush tax cuts expire there will be several changes to the tax code. Under the Clinton administration, the top tax rates for ordinary income from wages were 36% and 39.6%. The Bush tax cuts reduced the top marginal rates to 33% and 35%.

More importantly, the Bush tax cuts reduced taxes on capital gains and dividends. The capital gains tax was reduced from 20% under Clinton to 15% under Bush. Dividends under Clinton, were taxed as ordinary income and subject to the rates presented in the paragraph above. Under Bush they are taxed at the capital gains rate of 15%

Lastly, the estate tax was eliminated in 2010 and returns in 2011 if the Bush tax cuts expire.

The change in the marginal tax rates on ordinary income should have no affect on small business. In the first place only 2% of small businesses have taxable income that would place them in the top income bracket. The top tax rate applies to taxable income greater than $369,000 this year and would be closer to $400,000 in 2011. ( Taxable income is different from gross income. It is the income that remains after deductions and exemptions.) Consider a household with taxable income of $500,000 in 2011 under the Clinton and Bush tax rates. The household would pay an additional tax of $4,600 on its ordinary income above $400,000. This is hardly the kind of thing that should affect the decision to hire additional labor. Businesses hire additional people when they have an opportunity to produce enough new revenue to cover to cover the cost of the additional labor. On the other hand, a corporate executive with income of $1.4 million would pay an additional tax of $46,000 on the million dollars above $400,000. They are the real beneficiaries of the cut in the marginal tax rate on ordinary income.

Small businesses are not affected by the changes in the capital gains tax or the tax on dividends.
Of course, they may trade some assets that produce a capital gain but generally these assets are not part of the business. The real beneficiaries of the capital gains tax cuts are corporate executives who receive the majority of their income in stock options. They pay 5% less on their capital gains under the Bush plan than they do under the Clinton tax plan. For example, an executive who sold stock options that produced a gain of $1 million would an additional tax of $50,000. A top executive who realized a gain of $10 million would pay an additional tax of $500,000. That would make a campaign contribution to the GOP worthwhile if they could retain the Bush tax cuts. Moreover, since they are also the ones who own most of the stock in dividend paying companies, they benefit enormously from the much lower tax rate on dividends under the Bush regime.

The elimination of the estate tax benefits a very small number of households with estates over $4 million. Very few small businesses are in this category, and it is hardly a consideration that would affect their decision to hire additional labor.

To summarize, tax policy under Bush was not really about tax cuts. It was about shifting the burden of taxation from taxes on capital to taxes on wages. Taxes as a percent of national income have been relative stable over the years at around 20% of national income. When the taxes on capital are reduced, without a cut in government expenditures, the tax burden is shifted elsewhere. It has been shifted to those who are taxed primarily on wages.

We should also recall that the US economy grew at a 2.39% rate between 2001 and 2007 under Bush. His shifting of the tax burden from capital to wages did nothing to stimulate growth. Under Clinton, with higher taxes on capital, the economy grew much faster, and even in the 70's when the highest tax rate on income, equivalent to $1 million today, was 70%, the economy grew at 3.21%.

If the primary beneficiaries of the Bush tax cuts are not small business owners but corporate executives who are in a position to fund election campaigns, one might ask why the GOP claims that the expiration of the Bush tax cuts will hurt small businesses. The answer is simple. It is a much stronger campaign slogan than defending a shift of the tax burden from the wealthiest Americans to middle and upper- middle class wage earners.

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