Tuesday, November 27, 2012

Muddled Thinking on Small Business Taxes

I am currently taxed as an independent contractor, which while not really a small business makes up the majority of what are referred to as small businesses in political rhetoric. Having some direct experience of this is what made me look really derisively at this article from the Washington Post. Specifically, this claim:

What policymakers fail to realize is that most small business owners, who also employ most of the country’s workforce, declare their business profits on the owner’s personal income tax return and are taxed at the personal income tax rate. Given that the net income number for many will be over $250,000, the proposed tax hikes could have a dramatic effect on small businesses and the growth and hiring decisions they will make.

Another point policymakers overlook is that business owners will ultimately pass this cost on to the middle class by raising prices on goods and services, possibly triggering layoffs and stalling hiring. With the combined tax increases and the cut in spending, it equates to roughly half a trillion dollars being removed from our economy. The U.S. gross domestic product will fall, causing the U.S. to face a possible downgrade by Moody’s. If that happens, business lending will shrink to levels near or worse than those we experienced in 2008.

The technical term for this crap is bullshit. Taxes on profit only act as a cost to be passed on when assuming liquid investors comparing the investment versus a normal rate of return (not always a realistic assumption even in public corporations, and an assumption that only works if the business has the market power to do this, if it is already at the optimal price for its rate of return shifting from this can only lower net profits). This does not characterize small business owners heavily invested in illiquid assets and deriving a significant portion of that capital from their own labor. If a small business could raise its rate of return by raising prices it would have done so already, small business is competitive and can't afford to miss opportunities like this. Raising prices due to higher taxes would just result in that business losing sales and the owner possibly avoiding that tax hike through a lower net income; hardly the desired result.*

Since small businesses also face competition from other, newer, small businesses whose owners are not yet making over $250,000 net there is also no possibility of coordination; a wealthier small business owner that tried to raise prices would find themselves less competitive relative to a newer entrant still not facing the higher tax bracket.

There is also no reason to see how the tax hike could possibly impact hiring decisions, retaining 60.5% of profits vs. retaining 65% of profits from the marginal hire doesn't have any impact on whether or not that new hire is profitable at the margin. It does reduce the magnitude of the incentive, but the magnitude of the incentive only seems to matter with large swings or when relative incentives change (this does increase incentives to shift income to capital gains if the capital gains rate is not raised, but given the large existing discrepancy I believe this is largely baked in).

The rest of the article is much better when it discusses specific provisions regarding tax write offs for investment in new equipment. These provisions could be problematic. But the quoted paragraphs are the kind of ideological claptrap I come across in business books all the time whose purpose seems to be fluffing the egos of business owners rather than carefully thinking through making good business decisions. All this shows is that you don't really need to think through what is actually going on to make your business successful, all you need to do is focus on the narrow task you've set yourself rather than the wider world. Fair enough if this stuff helps sponsor entrepreneurs, but newspapers shouldn't be propagating obviously wrong, ideologically motivated nonsense.

*Alternately, this may also increase a business owners preference for tax deductible investments since the marginal cost to current consumption has become less with higher taxes. An owner may choose to spend more on creditable health care coverage or seek investments to raise long run profits to reach the former pre-tax income. The main individuals this hurts are those with highly volatile year on year income, but most business owners can shelter this money in business investments at least temporarily to smooth this; though this is a hassle no one really wants to bother with.

[Update: For clarifications sake, I am not arguing that firms generally can't pass on costs, such as the corporate tax. What I'm arguing is that passing on costs requires a degree of market power and sales volume that publicly traded corporations tend to have and small businesses tend not to. That Toyota can get away with raising the price on a Camry to reach a profitability target (and experience a trade off of market share vs. profitability with all the relevant consequences) does not mean that your local car wash or dry cleaner can do the same because the tax rate on individuals went up. This should be fairly obvious to anyone that formally studied economics and thought through the implications of the models, but I guess it gets skipped in the economics for business school courses.]


  1. My personal experience on this subject is that an across-the-board price raise from a business is a rare beast. Businesses will tend to raise their prices to pass on higher costs to the consumer if they have market power or if they have an increase in fixed costs.

    The former example, which you harped on in a theoretical sense here, is one that I am familiar with in my industry. I recently worked with a petrochemical intermediates company that's had a merry old time of increasing prices to its stranded customers. Those customers have few alternatives so they have to take the price increases, ironically introduced as "service fees" since the intermediate producer is contractually obliged to link their pricing to that of some benchmark feedstocks and chemicals. The rest of the industry has rather gleefully followed suit.

    The second example is just what I see on Jan 1 whenever the rent goes up at my local laundromat. I think since taxes count as a variable cost, there's not really much justification for this WaPo article.

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