Small business has rightly emerged as a flashpoint in the presidential campaign. With corporate profits high but the labor market still weak, looking to smaller firms or new startups as the leading possible source of job growth is completely reasonable. Unfortunately, in the presidential debate this week and the vice presidential debate the week before, the Republicans mostly focused on tax arguments that don’t make sense while the Democrats nitpicked Republican claims without offering ideas of their own. There are plenty of good ideas out there to spark small business hiring, but to make them happen, politicians need to take a break from their obsession with arguing about the top marginal-income tax rate and look instead at payroll taxes and monetary policy.
The usual dance on small business is this: Democrats accurately accuse Republicans of favoring tax policy that’s favorable to rich individuals, and then Republicans instead pivot to the idea that some rich individuals are actually rich small-business owners.
“The president,” Paul Ryan warned during the VP matchup, “wants the top effective tax rate on successful small business to go above 40 percent”—by which Ryan meant that under Obama’s policies, rich people with adjusted gross incomes of more than $250,000 would pay a high effective tax rate whether or not they got rich by owning a small business. This, Ryan claimed, would stifle hiring and would “cost us 710,000 jobs.” Joe Biden rebutted Ryan not by disputing the policy logic but by disputing the semantics. He noted that most small-business owners aren’t that successful. As to those who are rich, he said, “let me tell you who some of those other small business are: hedge funds that make $600 million, $800 million a year—that’s what they count as small businesses because they’re pass-through.”
And Biden is right. Some rich small-business owners are rich because they’re partners in hedge funds. Others might be part-owners of a medical practice or a law firm. But by the same token, some might own Taco Bell franchises or used car dealerships, or write smartphone apps. There are successful business owners in all different lines of work, and all different kinds of firms have some employees. The question is whether taxing those business owners really discourages hiring.
Romney tried to argue that it does. “If you bring rates down,” he said Tuesday night, “it makes it easy for small business to keep its capital and hire.” Later he reiterated that “when you keep rates down, it makes it easier for those businesses to keep more money and hire more people.”
Obama offered no proper response to this, but Romney is totally wrong. To see why, imagine Romney was talking about some other kind of tax. State and local government, for example, typically charges your Taco Bell franchisee substantial sales and property taxes. Lower sales taxes might mean more demand for tacos, and thus make it profitable to hire some extra people to sell them. Lower property taxes would make it cheaper to open a whole new Taco Bell and hire people to staff it. But lower personal income taxes for the owner of the franchise have nothing to do with hiring. The tax is levied on the business’s profits and any money you pay your employees is, by definition, not profits and thus not taxed. If anything, the causation goes the other way. You might have a worker you feel sentimental about who’s not actually doing a very good job. At a high marginal tax rate, the warm fuzzy feelings you get from not firing him might exceed the benefit of extra profits. Less taxation of profits increases the benefits of profit-maximizing layoffs.
Presidents don’t control these state and local taxes, so it’s understandable that they didn’t come up. But taxes on human labor are also a kind of tax on business inputs. A standard economic account is that it’s the taxes on a Taco Bell’s workers that might be bad for business, not the taxes on a franchise’s profits. People take jobs in order to gain after-tax income, but employers need to pay pre-tax income in order to hire them. This “tax wedge” means that sometimes when you calculate a pre-tax wage that’s worth paying, the after-tax income is too low to make the job worth taking. High-end income tax rates are relevant to this since businesses do hire highly skilled professionals, some of whom may have more than $250,000 in taxable income. But clearly that’s not the majority of the workforce.
Which is why it’s a shame neither candidate tackled the federal tax that really does hold small business hiring back—the payroll tax. As part of the 2010 deal to extend the Bush tax cuts, Congress created a temporary cut in the payroll taxes that are levied on workers of all skill levels. This works as demand-side stimulus since it puts more money in people’s pockets, but it’s also a supply-side measure that makes it cheaper to add staff. Unfortunately, this measure is set to expire at the end of the year, and neither party seems very interested in pushing for an extension. Instead, all eyes remain on the fight over the Bush tax cuts, even though Goldman Sachs’ economic forecasters think the payroll tax-cut expiration could shave a dire 0.8 percentage points off next year’s growth. The topic of taxes on non-rich people’s income isn’t in either party’s ideological wheelhouse, but since most of us aren’t rich—including both the workers at and the owners of the vast majority of small businesses—it’s a much bigger deal than the highly charged disagreement over top rates.
The incredible growth of state-level occupational licensing schemes also continues to go completely ignored in national politics though business owners cite it as the No. 1 policy drag on their success. Even very conservative states such as Georgia are finding ways to make things worse on this front. Like sales and property taxes, it’s not really a federal issue, but opinion leadership from the top could make a difference. Instead, for all the rhetorical fealty politicians pay to small businesses, politicians are much more interested in high-end income taxes than on the issues that really matter.