Cutting State Personal Income Taxes Won’t Help Small Businesses Create Jobs and May Harm State Economies
End Notes
[1] Donald Bruce and John Deskins, “Can State Tax Policies Be Used to Promote Entrepreneurial Activity?,” Small Business Economics, 2012.
[2] Matthew Knittel, Susan Nelson, Jason DeBacker, John Kitchen, James Pearce, and Richard Prisinzano, "Methodology to Identify Small Businesses and Their Owners," Office of Tax Analysis, U.S. Department of Treasury, August 2011, Table 14; http://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/OTA-T2011-04-Small-Business-Methodology-Aug-8-2011.pdf. (Hereafter referred to as “Treasury study.”) 24.3 percent of all individual returns reported some amount of small business income; this figure does not include dividends from investments in the stock of taxable corporations. 14.0 percent of all returns reported income from an active small business.
[3] The Treasury study used a variety of criteria to screen out from the count of small businesses those that consist of an individual providing employee-like services to a single company, people renting out a residence or farmland with no active management of the property, or business entities used to enable multiple individuals to pool their assets for passive investment in other companies. (The actual screening criteria used in the Treasury study are somewhat more detailed than just described.)
[4] Analysis by the Institute for Taxation and Economic Policy for Policy Matters Ohio, “Kasich Tax Proposal Would Further Tilt Tax System in Favor of Ohio’s Affluent,” February 2013; http://www.policymattersohio.org/wp-content/uploads/2013/02/TaxCuts_Feb20132.pdf.
[5] Treasury study, Table 4.
[6] Treasury study, Table 6.
[7] Treasury study, Table 15.
[8] Treasury study, Table 13. Many partners, stockholders in S-corporations, and members of LLCs either: a) own businesses that do not engage in sufficient activity to be considered a bona fide business; b) own large businesses, not small businesses; b) own businesses that do not employ anyone other than themselves; c) are owners of businesses that are entirely engaged in passive investing in other businesses; or d) are themselves mere passive investors in the businesses they own with no operational role and no authority to hire people, i.e., “create jobs.” According to the Treasury study, 78 percent of taxpayers reporting partnership, LLC, or S-corporation income fall into one of these four categories, meaning that only 22 percent potentially have any hiring authority in small businesses that currently have (non-owner) employees.
[9] Jane G. Gravelle and Sean Lowery, “Small Business and the Expiration of the 2001 Tax Rate Reductions: Economic Issues,” August 1, 2012, p. 7.
[10] Table of state personal income tax rates compiled by the Federation of Tax Administrators; available at http://www.taxadmin.org/fta/rate/ind_inc.pdf.
[11] Erik Hurst and Benjamin Wild Pugsley (University of Chicago), “What Do Small Businesses Do?” August 2011.
[12] To be sure, self-employed workers are an important part of the U.S. economy. According to the Treasury study (Table 8), in 2007 there were 19 million bona fide small businesses that were such “non-employer” firms.
Nonetheless, state tax bases are finite and are called on to finance a wide array of critical services. Hard questions need to be asked about whether states should devote the limited resources they have available for economic development to encouraging the creation of businesses that are unlikely ever to employ anyone other than one or two owners — particularly when the mechanism is as poorly targeted as state income tax cuts are. In any case, those who propose state personal income tax cuts in the name of job creation do not profess that their goal is the creation of a lot of small “mom and pop” businesses. To the contrary, they give every indication of being focused on attracting or incentivizing the creation of the next Facebook or Amazon, that is, firms that develop an innovative product, service, or business model, grow rapidly, and create a large number of jobs.
[13] “Only 10 percent of all new businesses reported that they plan to develop proprietary technology, processes, or procedures in the future.” “Nearly 80 percent of all new businesses report that they have no plans for research and development to be a majority priority for the business when they are establishing the business.” “What Do Small Businesses Do?” p. 25.
[14] John Haltiwanger, Ron S. Jarmin, and Javier Miranda, “Who Creates Jobs? Small vs. Large vs. Young,” August 2011; http://econweb.umd.edu/~haltiwan/size_age_paper_R%26R_Aug_16_2011.pdf.
[15] A recent study found that start-up firms receiving venture capital investments are likely to grow much more rapidly and ultimately create a much larger number of jobs than similar firms not obtaining venture capital. The study found that fully 47 percent of firms receiving such investments had no revenue in their first year of operation, let alone any profit. Moreover, for the firms that were profitable, the profitability dropped sharply after the venture capital investment as the firms use the money to hire more higher salary employees and to grow rapidly. It took an average of nine years for the rate of profit of venture-capital financed startups to equal the rate of profit of start-ups that did not obtain venture capital investments. Manju Puri and Rebecca Zarutskie, “On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms,” National Bureau of Economic Research Working Paper 14250, August 2008.
A second study found that “while investing in the development of intellectual property (specifically, patents) in young ventures allows them to grow their sales, this growth is not profitable (at least in the short run).” Maija Renko, “Innovations and the Performance of New Ventures: Evidence from the Kauffman Firm Survey,” unpublished, 2011; http://www.icsb.org/assets/icsbgw_renko_fullpaper.pdf. Emphasis added.
[16] Douglas Elmendorf, Director, Congressional Budget Office, “Policies for Increasing Economic Growth and Employment in 2012, and 2013,” Testimony to the Senate Budget Committee, November 15, 2011; http://www.cbo.gov/sites/default/files/cbofiles/attachments/11-15-Outlook_Stimulus_Testimony.pdf.
[17] This same argument is made to justify cuts in state corporate income taxes, and it is wrong for the same reason discussed here. See: Michael Mazerov, “Cutting State Corporate Income Taxes Is Unlikely to Create Many Jobs,” Center on Budget and Policy Priorities, September 14, 2010; https://www.cbpp.org/sites/default/files/atoms/files/9-14-10sfp.pdf.
[18] Moreover, any state tax savings resulting from a cut in the state personal income tax rate(s) applicable to small business profits is likely to be significantly offset by higher taxation of the same profit by the federal government and other states.
First, since state personal income taxes are deductible in calculating federal income tax liability, lower state tax liability results in higher federal liability. This effect can eliminate up to one-third of any tax savings a cut in the state rate would otherwise provide to a small business.
Second, if a state exempts or cuts the tax rate on small business income, much of the intended tax savings will result in higher tax liability in other states. Any income of a pass-through business that is received by out-of-state owners is also potentially taxable by the states in which they reside. Such states give a dollar-for-dollar credit against their taxes for any income taxes imposed by the state in which the business operates. But if that state exempts or cuts taxes on that income, other state(s) in which the owners reside will grant smaller credits and thus tax more of the income themselves. Once again, cutting or eliminating state personal income taxes on small business owners proves itself to be an extremely inefficient means of assisting them.
[19] Manju Puri and Rebecca Zarutskie, “On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms,” National Bureau of Economic Research Working Paper 14250, August 2008, Figure 2a.
[20] “[T]here is no direct effect on the incentive to hire workers from changes in the owner’s tax rate . . .” “Because the costs of labor are deductible, tax rates would matter only if the employer expanded the scope of his efforts or investment to increase the size of the firm.” [Emphasis added.] Jane G. Gravelle and Sean Lowry, “Small Business and the Expiration of the 2001 Tax Rate Reductions: Economic Issues,” Congressional Research Service, August 1, 2012, pp. 13-14. These quotes are taken from an analysis of the implications of federal personal income taxes for small business hiring decisions, but they apply equally to state personal income taxes.
[21] This research is summarized in Chye-Ching Huang, “Recent Studies Find Raising Taxes on High-Income Households Would Not Harm the Economy,” Center on Budget and Policy Priorities, April 24, 2012, p. 7 (and associated endnotes); https://www.cbpp.org/sites/default/files/atoms/files/4-24-12tax.pdf.
[22] CBO reports the total wage elasticity assumed for various income classes, with total wage elasticity being the percentage change in hours worked that would result from a 1 percent increase in both after-tax income and the after-tax wage rate. The total wage elasticities decline steadily as income increases: for the lowest decile, 0.168; for the second decile, 0.126; for the third and fourth deciles, 0.084; for the fifth and sixth deciles, 0.063; and for the top four deciles 0.028. (The study on which these estimates are based does not disaggregate the elasticities for the top four deciles.) “The Effect of Tax Changes on Labor Supply in CBO’s Microsimulation Tax Model,” Congressional Research Service Background Paper, April 2007, http://www.cbo.gov/ftpdocs/79xx/doc7996/04-12-LaborSupply.pdf.
[23] Donald Bruce and John Deskins, “Can State Tax Policies Be Used to Promote Entrepreneurial Activity?” Small Business Economics, 2012.
[24] Yasuyuki Motoyama and Brian Danley, “An Analysis of the Geography of Entrepreneurship: Understanding the Geographic Trends of Inc. 500 Companies Over Thirty Years at the State and Metropolitan Levels,” Ewing Marion Kauffman Foundation, September 2012, p. 22; http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2145480_code861608.pdf?abstractid=2145480&mirid=1.
[25] Thomas A Garrett and Howard J. Wall, “Creating a Policy Environment for Entrepreneurs,” Cato Journal, Fall 2006; http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2006/11/cj26n3-7.pdf.
[26] Timothy J. Bartik, “Small Business Start-Ups in the United States: Estimated of the Effects of Characteristics of States,” Southern Economic Journal, April 1989. Consistent with the discussion below of the importance to entrepreneurial businesses of high-quality public services, this study found a positive relationship between manufacturing start-ups and both state per-pupil spending on K-12 education and the density of state highway networks.
[27] As economists Michael S. Dahl and Olav Sorenson observe:
“[E]ntrepreneurs cannot easily transplant their social capital. The relationships that can help them to spot opportunities and to assemble the resources necessary for an organization to exploit those opportunities are concentrated in the regions in which they have lived and worked. . . . the potential financiers and employees they might know also tend to reside in those same regions. . . As a result, entrepreneurs should benefit from locating their businesses in the (home) regions in which they have deep social roots, and therefore should tend to open operations in these locations.”
Michael S. Dahl and Olav Sorenson, “Home Sweet Home: Entrepreneurs’ Location Choices and the Performance of Their Ventures,” Management Science, June 2012.
[28] Claudio Michelacci and Olmo Silva, “Why So Many Local Entrepreneurs?” Review of Economics and Statistics, November 2007.
[29] Jerry T. Parwada, “The Genesis of Home Bias? The Location and Portfolio Choices of Investment Company Start-Ups,” Journal of Financial and Quantitative Analysis, March 2008.
[30] Edward B. Roberts and Charles Eesley, “Entrepreneurial Impact: The Role of MIT,” Ewing Marion Kauffman Foundation, February 2009; cited in Erin Sparks and Mary Jo Waits, “Growing State Economies: Twelve Actions,” National Governors Association Center for Best Practices, 2012; http://www.nga.org/files/live/sites/NGA/files/pdf/11HEINEMAN12ACTIONS.PDF.
[31] Gary Kunkle, “Pennsylvania’s High-Growth Companies, 2004-2009,” Team Pennsylvania Foundation, May 2011; http://teampa.com/wp-content/uploads/2011/06/Team-PA-Higro-Research-Update.pdf.
[32] Junfu Zhang and Nikesth Patel, “The Dynamics of California’s Biotechnology Industry,” Public Policy Institute of California, 2005, pp. 69-71; http://www.ppic.org/content/pubs/report/R_405JZR.pdf.
[33] William R. Kerr and Ramana Nanda, “Location Choice for New Ventures: Cities,” Harvard Business School case 9-811-106, revised February 23, 2012.
[34] Joe Cortright and Mary Jo Waits, “Growing State Economies: A Policy Framework,” National Governors Association, July 2012, pp. 12-13; http://www.nga.org/files/live/sites/NGA/files/pdf/11HEINEMANFRAMEWORK.PDF.
[35] See, for example, Richard Florida, The Rise of the Creative Class (2002); Timothy R. Wojan and David A. McGranahan, “Ambient Returns: Creative Capital’s Contribution to Local Manufacturing Competitiveness,” Agricultural and Resource Economics Review, April 2007.
[36] Hal Woman, Alice Levy, Garry Young, and Pamela Blumenthal (George Washington University), “Economic Competitiveness and the Determinants of Sub-National Area Economic Growth,” report for the Office of Revenue Analysis, District of Columbia Office of the Chief Financial Officer, September 30, 2008, p. 41; http://www.gwu.edu/~gwipp/Competitiveness%20lit%20rev%20final%20word.pdf.
[37] Erin Sparks and Mary Jo Waits, “Growing State Economies: Twelve Actions,” National Governors Association Center for Best Practices, July 2012; http://www.nga.org/files/live/sites/NGA/files/pdf/11HEINEMAN12ACTIONS.PDF.
[38] Dane Stangler, Robert Litan, and Yasuyuki Motoyama, “Startup Act for the States,” Ewing Marion Kauffman Foundation, January 2012; http://www.kauffman.org/uploadedfiles/soe_address_2012.pdf .
[39] The NGA study unfortunately begins with a rather boilerplate assertion that “Competitive tax rates, including income, sales, property, and other business taxes do make a difference. Each state needs to assess its overall tax climate and work to improve its competitiveness structure.” However, the paper does not cite a single study to back up that assertion, makes no attempt to describe what it means by a competitive tax structure, and makes no further tax policy-related recommendations. The only tax-related recommendation that the Kauffman study authors make is that states simplify their corporate income tax structures, by which they appear to mean primarily scrubbing them of the wide array of specific tax incentives that have been added over the years: “What a state must avoid are taxes and regulations that distort business activity by favoring one sector over another. Tax credits and incentive programs do just this, distorting the environment not only for new and young firms but for all other companies in the state as well. . .”