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Friday, October 5, 2012

Small Business and the Presidential Debate -- Who are the 3%?

The following exchange from the debate interested me, for reasons I'll give below:

OBAMA: And we do have a difference, though, when it comes to definitions of small business. Under -- under my plan, 97 percent of small businesses would not see their income taxes go up. Governor Romney says, well, those top 3 percent, they're the job creators, they'd be burdened.

But under Governor Romney's definition, there are a whole bunch of millionaires and billionaires who are small businesses. Donald Trump is a small business. Now, I know Donald Trump doesn't like to think of himself as small anything, but -- but that's how you define small businesses if you're getting business income.
And that kind of approach, I believe, will not grow our economy, because the only way to pay for it without either burdening the middle class or blowing up our deficit is to make drastic cuts in things like education, making sure that we are continuing to invest in basic science and research, all the things that are helping America grow. And I think that would be a mistake.

LEHRER: All right.
ROMNEY: Jim, let me just come back on that -- on that point, which is these ...
LEHRER: Just for the -- just for record ...
ROMNEY: ... the small businesses we're talking about ...
LEHRER: Excuse me. Excuse me. Just so everybody understands, we're way over our first 15 minutes.
ROMNEY: It's fun, isn't it?
LEHRER: It's OK, it's great. No problem. Well, you all don't have -- you don't have a problem, I don't have a problem, because we're still on the economy. We're going to come back to taxes. I want move on to the deficit and a lot of other things, too.
OK, but go ahead, sir.

ROMNEY: You bet. Well, President, you're -- Mr. President, you're absolutely right, which is that, with regards to 97 percent of the businesses are not -- not taxed at the 35 percent tax rate, they're taxed at a lower rate. But those businesses that are in the last 3 percent of businesses happen to employ half -- half of all the people who work in small business. Those are the businesses that employ one-quarter of all the workers in America. And your plan is to take their tax rate from 35 percent to 40 percent.

Now, and -- and I've talked to a guy who has a very small business. He's in the electronics business in -- in St. Louis. He has four employees. He said he and his son calculated how much they pay in taxes, federal income tax, federal payroll tax, state income tax, state sales tax, state property tax, gasoline tax. It added up to well over 50 percent of what they earned. And your plan is to take the tax rate on successful small businesses from 35 percent to 40 percent. The National Federation of Independent Businesses has said that will cost 700,000 jobs.

I don't want to cost jobs. My priority is jobs. And so what I do is I bring down the tax rates, lower deductions and exemptions, the same idea behind Bowles-Simpson, by the way, get the rates down, lower deductions and exemptions, to create more jobs, because there's nothing better for getting us to a balanced budget than having more people working, earning more money, paying more taxes. That's by far the most effective and efficient way to get this budget balanced.


I'm just trying to figure out who exactly these three percent are.  Are they all Donald Trump, or are they the guy in St. Louis?  What do the statistics say?

First, let's try to get a handle on what the candidates are saying above.

Small business income is considered regular income. So if you raise the income tax on some segment of the population, you are going to be raising taxes on small businesspeople in that segment.   Obama says he won't raise taxes on 97% of small businesses.  From elsewhere, we know that he's not going to raise taxes on people who make less than $250K.  Based on these two figures, it follows that he won't raise taxes on small businesses having incomes of $250K or less.  It also follows that he will raise taxes on small business owners whose incomes exceed $250K.  From the figures that BOTH candidates seemed to agree on, this means that 3% of small businesses are owned by people making more than $250K and that under Obama's plan these people would be taxed more.  Romney, on the other hand, would not tax them more, because he says that these rich small business owners employ half the workers in the United States.

Here is some info on SBA size requirements (for purposes of determining if a business is a "small" business) from SBA site:

-- Manufacturing: Maximum number of employees may range from 500 to 1500, depending on the type of product manufactured;

-- Wholesaling: Maximum number of employees may range from 100 to 500 depending on the particular product being provided;

-- Services: Annual receipts may not exceed $2.5 to $21.5 million, depending on the particular service being provided;

-- Retailing: Annual receipts may not exceed $5.0 to $21.0 million, depending on the particular product being provided;

-- General and Heavy Construction: General construction annual receipts may not exceed $13.5 to $17 million, depending on the type of construction;
-- Special Trade Construction: Annual receipts may not exceed $7 million; and

-- Agriculture: Annual receipts may not exceed $0.5 to $9.0 million, depending on the agricultural product.

So far so good.  We really need to get more data, but this already tells us that a small business CAN be pretty big -- you can employ up to 1500 people if you're in manufacturing; and you can have "receipts" of over $20 million if you're in some types of services and retailing.

We don't yet have data on exactly who the 3% are.  One can readily imagine that there are a good number of "big" small businesses out there.  In fact, Romney tells us that the 3% are responsible for half of the nation's jobs.  Based on this, it seems highly unlikely that the guy with the 4 employees in St. Louis is even in the 3%.

Low hanging fruit:  Without knowing any breakdowns whatsoever, we can see a fallacy in Romney's argument.  Romney's basic idea is that he will NOT raise taxes on anyone with an income greater than $250K.  And his justification is that some people with incomes over $250K are small business owners and job creators.  But until someone tells us how many of them are small business owners, we must reject his argument.  As we saw above in "Who Are the 1%?", people earning over 250K are typically doctors, lawyers, real estate developers, consultants, bankers, etc.  While some of these people certainly provide jobs, they are not all necessarily "growing" businesses.  So if we're trying to help rich small business owners, there's no reason that we need to help the rest of the rich as well.

And that leads to the second question -- Do we need to help rich small business owners by giving them tax breaks?  By definition, these are people whose small businesses are generating more than $250K in income for them.

The reason they are making this income is simple economics -- this is the money they take in from their customers, minus the money they pay for material and labor.

Read what I just wrote again.  And then try to think of circumstances under which taxing this profit would cause a business to stop hiring employees.

A business will hire a new employee when the business realizes that it can get more money from customers than it has to pay in expenses, including the employee's salary.  In other words, the decision to hire another employee will typically have nothing whatsoever to do with your tax rate.  If I have a great product, but am having trouble getting the word out, I might decide to hire a new sales person, on the theory that the sales person will cause more sales to occur, and as a result my profits due to that sales person will exceed what I had to pay that salesperson.

Obviously, there is always a risk involved in hiring a new employee.  If the employee ends up costing me more money than I can make off of his work, I lose money.  So presumably an employer does some kind of calculation before hiring.  He makes his best guess as to the probabilities of different outcomes, and chooses the outcome that will give him an expected income greater than zero (or significantly greater than zero, if he is risk averse).  Some employees will turn out to be real profit centers; others, not so much.  And if there's an economic downturn or other unforeseen event, each employee on the payroll will be a problem.

Taxes DO play a part in this calculation, but really only a very minor part.  For example, say I hire an employee for $100K, on the thought that I'll get $110K back, i.e. I'll make $10K off of the employee.  At the 35% tax rate, I'd get to keep $6500 of the $10K; whereas at 40%, I'd get to keep $6K.  I might not do the hire if I thought the employee would likely mean considerably less than the $10K, but there are very few cases where the difference between the possible outcomes due to taxes (in the example given, merely 0.5% of the investment in the employee) will make the difference between hiring and not hiring.  In fact, the GREATER this percentage, the MORE likely I am to do the hire, since that will suggest that I am making more money per employee.

I also found this article by Sarah Ayres of the Center for American Progress.

The article confirms what I'm saying above -- "Small-business owners overwhelmingly are not millionaires, and the vast majority of millionaires do not make their millions from small business."

-- it notes that a report by the Office of Tax Analysis at the U.S. Treasury defines a “small business” as "a flow-through entity that engages in business activity and has income over $10,000 but less than $10 million. A small business is then considered an employer if it has at least $10,000 in labor deductions."

    Less than 4 percent of small business owners are millionaires

-- there were 3.8 million small-business employers in the United States in 2007.

--3.3 percent of small businesses are owned by millionaires (a bit different from the statistic that both parties seemed to agree to in the debate -- that 3% of small business owners earned 250K or more.

I'm quoting the next one in full, because the text doesn't seem to match the chart (Figure 2) in two ways.  The text quite clearly states that only about 20% of small business income goes to millionaires, but the title says "less than 20% of small business owners are millionaires" (whereas above, we've been told it's 3%), and the pie chart is labeled "millionaires' income by source" which bears nto relation to the text or the rest of the pie chart.   But if you look past the label on the chart, the numbers do match up -- apparently millionaires only do take home about 20% of small business income.
    Less than 20 percent of small business employers are millionaires
  • "Millionaires take home only 19 percent of small-business employer income. Small-business owners made $183 billion in 2007. Most of this income was earned by employers who made less than $1 million that year. In fact, the majority was earned by employers who make less than half that; 60 percent of small-business employer income went to individuals who earned less than $500,000 [PF Note: possibly wrong, since chart gives 57.8% for people making 200K-1M]. About a quarter was earned by employers making less than $200,000 a year. Most of the income earned through small businesses does not go to millionaires. It goes to businessmen and businesswomen who make much less. (See Figure 2)"
  • Less than 3 percent of millionaires' income comes from small businesses
    -- And Figure 3 is fairly self-explanatory -- millionaires are overwhelmingly NOT getting their income from running small businesses.

So based on all of this, I'm baffled why Obama didn't give a more coherent response to Romney's point about the 3% (i.e. that 3% of small business owners are rich small business owners who provide more than half of the jobs in this country).

The answer would have been:

1) That's no reason for lowering (or keeping low) taxes on ALL rich people, since the statistics show that only a tiny percentage of rich peoples' income has anything to do with small business.

2) And remember, the 3% of small business owners that we're talking about are those who are making more than $250K from their business [if that's right; the graph above seems to suggest that about 25% make over $200K, and that the 3% is millionaires].  Why shouldn't they pay the same tax rate as other people making that kind of money/

3) There's no showing anywhere that increasing taxes from 35% to 40% is going to significantly affect hiring decisions.  If you're thinking about hiring a new worker, you will only do that if you are pretty sure you'll make enough money off of that worker to offset the risks involved of the hiring.  That last 5% is a trivial amount, as PriceFixer has shown in his/her blog.  It is highly unlikely to affect hiring decisions -- if you thnk you'll make good money off of another hire, you'll do it, even if you end up paying an extra 5% of your profits (which might translate to as little as 0.5% of your investment in the new hire) to the government. 

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