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How increases in the top individual rate beat up the successful business

October 22, 2008

Senator Obama proposes to increase the top tax rates for "the rich." Those who support higher rates like to point out how few taxpayers will see the higher rates on their returns. When people point out that small businesses often pay taxes at individual rates, the rate hikers say most small businesses won't be affected.

If you count every moonlighter, Mary Kay seller and part-time real estate agent, sure, not many of these people will be at the top rate. But Tax Vox asks the right question: what about the serious ones? Because they're the ones that really matter.

My career has been spent working with the successful small businesses who would be hit by the proposed Obama rate increase. To understand what this would do to their businesses, and the economy, it might be helpful to see how this works. While these taxpayers are a small portion of taxpayers with K-1 or Schedule C income, they are the ones who build businesses and hire people.

The successful businesses might have sales of anywhere from $10 million to over $100 million. They might generate taxable income of $1 million to $20 million and up. They have dozens to over a hundred employees, with activities in one to twenty or more states.

So what happens to this money? Do the owners put it in a gilded vault and bathe in it, like Scrooge McDuck? Do they spend it all on airplanes and yachts?

These entrepreneurs typically have bankers or co-investors who impose strict limits on how much earnings can come out of the businesses. They usually only get to take enough cash out of the businesses to pay the individual tax that the business income adds to their returns. The banker or co-investor will stop the private jet in a hurry.

A taxpayer with $10 million taxable income, for example, might only take $4 million out of the business to send to the IRS and to pay state taxes. The rest of the money stays in the business to buy inventory, develop new product, open new locations and hire new employees.

When the federal tax rate for someone with $10 million in taxable income goes goes from 35% to 45%, that just means another $1 million comes out of the business to go to the IRS. That million is no longer available to develop a new product. It's no longer there to open a new location in a different state. It's just gone, as is the economic activity and job growth it would cause.

To preserve business cash, management will shift more if its time from managing the business to managing taxes. More complex structures, perhaps with offshore activities, become more attractive. This generates tax consulting fees, for which I am grateful, but they are wasted resources to the economy.

Are these taxpayers significant to the economy? I think they clearly are. A picture can help illustrate this. The chart on the left is the one typically used by tax-hike supporters to say that only other people get screwed. The chart on the right shows how the tax hike affects taxpayers by the amount of the tax burden they now bear. The top bracket taxpayers pay a huge portion of the income tax burden. These are the entrepreneurs we're talking about.

Charts via Freakonomics

The chart on the right is the more accurate version of how much cash the proposals to increase the top rate will suck out of the economy.

There used to be a bi-partisan understanding that taxing "the rich" hurts the most important closely-held businesses. That understanding seems to be a campaign casualty.

UPDATE, 10/23: The Mechanisms of Owner Restraint

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