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The Reality of Raising Taxes at the Top, Part 4: Would Tax Increases Affect Small Businesses and Entrepreneurship?

April 30, 2012 at 12:37 PM

This blog series looks at how tax increases at the top affect economic growth. Today, we test claims that raising taxes on high-income people would heavily and adversely affect small businesses and entrepreneurs.

The claims don't hold up against the evidence, as our new paper explains. Consider, for example, a recent Treasury analysis that shows that only 2.5 percent of small business owners fall into the top two income tax brackets and that these owners receive less than one-third of small business income.

Even small business owners who would be affected by tax increases on high-income taxpayers would not likely reduce hiring or new investment. As Tax Policy Center co-director William Gale has noted, small businesses' effective income tax rate would likely be zero or negative, regardless of small changes in the marginal tax rates, for three reasons:

  • They can fully deduct their investment costs, bringing the effective tax rate on new investment to zero, regardless of the statutory rate.
  • If they use debt to finance the investment, the interest payments would be tax deductible, making the effective tax rate negative.
  • They can fully deduct wage payments, so the marginal tax rate should have minimal impact on hiring.

New data show that young, startup companies -- not small businesses generally -- create disproportionate numbers of new jobs. Additional research says that tax increases on high-income people don't seem to discourage entrepreneurs from creating new companies.

Findings on the link between income tax increases and business formation are mixed, but on balance they suggest that "higher tax rates are more likely to encourage, rather than discourage, self-employment," according to the Congressional Research Service. One reason why: taxes may reduce earnings volatility. The government bears some of the risk of a new venture by allowing tax deductions for losses and, in return, it taxes the profits of successful businesses.

Next in this series: a direct look at the relationship between raising taxes at the top and economic growth.


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