Taxing the Rich

| Tue Nov. 23, 2010 11:39 AM EST

Jim Puzzanghera of the LA Times writes today about whether small businesses are likely to reduce hiring if tax rates are raised on people making more than $250,000 a year. As he points out, big companies normally pay taxes at the corporate level:

But companies can also file as S corporations or partnerships. The business income flows to the owners or partners and is reported on their individual returns, so profits are taxed only once.

....[Rick] Poore, whose DesignWear Inc. takes in about $2.25 million a year [...] supports the expiration of the top-level tax cuts, pointing out that the costs of employees and equipment, such as a new automatic garment press he is purchasing, reduce his taxable income...."That's how small business works. We reinvest in our businesses. We try to minimize the amount of taxable income we have," he said.

Some small-business groups, such as the Main Street Alliance, a national network of state-based small-business coalitions, also support letting the top-level tax cuts expire. "Its disingenuous for people to say this is going to have such a horrible affect on small business if they let these expire," Poore said. "Either they're honestly ignorant of how this really works or they're being intellectually dishonest."

There are unquestionably small businesses who would be affected by the tax increase. But aside from the fact that only a tiny number of small businesses would have to pay the higher rates — perhaps 1-2% — it's important to understand how this works. As Poore says, in an S corporation, business income is passed through to the owner. So a tax increase doesn't affect the revenue of the business at all, and doesn't affect its incentives to invest in equipment or additional workers. What it does affect is the amount of income passed through. In other words, it modestly affects personal income, just as you'd expect.

If you think that would be a disastrous thing, fine. I disagree. But it has a very limited impact on the incentive of the business qua business to expand its operations. Those incentives are driven almost entirely by whether there's likely to be higher demand for their products in the future. Right now, financial uncertainty is high, and that's why business expansion is low. It has very little to do with new healthcare regulations or higher personal tax rates.