Wednesday, October 29, 2008

Giving Us The Business

Let's say you're a small business owner, perhaps you own a plumbing company with 5 employees, each one a master plumber earning $120,000 annually. Your business might be organized as a sole proprietorship, a joint venture with your spouse (if it's a mom & pop business), a partnership, a LLC, etc. (For a useful explanation, click here.) The tax code provides a variety of combinations of burdens and benefits depending on the nature of the organization, but regardless of the form of the business, one rule applies: Taxes apply to profits, which are calculated after subtracting expenses, and expenses include salaries of your employees (with some special rules for yourself and your family when classified as employees).

For simplicity, let's assume your business is a sole proprietorship and your five employees are not related to you. Now let's say that your small business is successful enough to generate more than $250,000 in after-expense profits. Let's imagine you run a stupdendously successful plumbing business that generates $400,000 in profits. Under the Obama tax plan, the marginal rate on your profits increases from 33% to 36% for dollars earned over $250,000 and from 35% to 39.6 % for dollars earned over $357,700. Using these numbers, you will pay an additional 3% on $127,700 (i.e., $3,831) plus an additional 3.6% on the last $42,300 (i.e., $1,522), for a grand total tax hike of $5,353. I suppose that's a substantial chunk of change, even for someone netting $400,000, but recall that the McCain argument is not that this is unfair to the owner of the plumbing business owner but that it somehow will dampen job creation.

Can that be? Whatever you pay your master plumbers comes out of the before-tax number, and so your labor costs haven't gone up. In fact, they've gone down, because we need to take account of what they earn. If we assume that each master plumber has 2 kids, saves for retirement, and has $100,000 outstanding on his mortgage, then, according to the Obama tax calculator, each of your high-wage employees saves about $1100 on his taxes. In my assumption that your business employs 5 master plumbers, that almost exactly cancels out your tax increase.

You might even try to get some of that money for yourself by paying your employees a little less, on the theory that their after-tax income will remain the same, but because wages are sticky, this will be hard to do. Perhaps we can imagine this is a new business, and you're trying to decide how much to pay your plumbers. The idea would be that you could pay them a lower gross under the Obama plan than under either current law or the McCain plan, without lowering their net pay. That in turn, increases your profits, substantially offsetting your own tax increase.

Not entirely, of course, since transferring money from employees with lower marginal tax rates to an owner with a higher marginal tax rate means that Uncle Sam gets more total. But that only means that the Obama plan makes it more efficient to pay your employees more. And the bigger point is that there is no logical way to explain how the Obama plan is bad for employees of small businesses. Sure, if Obama planned to raise the top marginal tax rate on small businesses to 95% or some comparable figure, then no one would have an incentive to create a small business that makes over $357,700/year. But with rates nowhere near that high in the Obama plan, it is hard to see how it could have any real negative impact on job creation.

Of course, relative to the current tax law, the Obama plan does redistribute about $5500 from our hypothetical plumbing company owner to the five employees working for him. But were it not for fear of being called a Marxist or worse, someone might point out that those employees are the drivers behind the success of our plumbing company owner's business in the first place.

Posted by Mike Dorf