With the election behind us and the fiscal cliff ahead of us talk is heating up about taxes and whether to increase taxes on the rich. As a business owner who competes every day for survival I have a front row seat on how economics work at the street level. This post will discuss raising income taxes on the so-called “Rich”. After all, successful small business owners make up the majority of this class.
Fluctuating profits are common in most small businesses. Some years profits are very good and another years not so good. Prudent cash management through cycles is important: profits from a good year need to be retained to get the business through bad years. And if the business is secure enough that it can focus on growth rather than just survival, profits can be invested for future growth. The problem is that current tax policy penalizes profitable businesses in their successful years, leaving less for employee hiring and development.
Consider a simple example of a business with gross revenues of $1 million. Of that million dollars say $300,000 is profit, before paying the owner’s compensation. The owner takes $100,000 as salary and another $50,000 as owners return on equity, just like a stockholder, leaving $150,000 available for reinvestment in the company. In a sales organization such as ours it costs approximately $100,000 to hire, educate and train a new salesperson before that employee becomes profitable. A phone and computer upgrade will cost another $50,000 in the coming year. The service department would really like to have a receptionist handle incoming phone calls and other clerical duties costing another $50,000. These are three smart and effective investments in the future of the company, but together cost 200,000, so the owner(s) need to decide which makes the most sense. All investments in human capital or technology will eventually return future profits, but it the challenge of the owners and financial advisors to choose which will get the money. After all, there is only 150,000 available.
Actually there isn’t. Because the profits of the company flow to the owner’s personal tax return, the owner is considered rich. Because the owner is rich, he or she gets to pay 33% of these profits to the federal government; in Massachusetts our state government gets another 5%. (In California, the state’s vig is now 13%!) When the Bush tax cuts expire, the federal rate will go to 39.6% bringing the government’s gross share to just under 50% in Massachusetts, and over 50% in California. If the business owner collects any passive income, such as rent, the new Obamacare tax will grab another 3.8% of this income too. It adds up fast.
So the amount available from the 150,000 profit is now $75,000; forget about a new receptionist. With the uncertainty of the fiscal cliff, we will also delay hiring a new salesperson. The new computer and phone systems may win in this case, or we may just hold the cash in case the economy continues to stay weak. But no new employees are going to be hired. There simply isn’t enough money left.
This example is what we face in a service / sales organization. The effect is magnified in businesses such as manufacturing and construction where annual swings in profit are greater. Big business (which lobbies Washington heavily) pays about 35% in taxes on profits, less than what small business owners pay, and are not in the president’s crosshairs for raising taxes. That’s what lobbying buys you.
The question today (if you want a job) should be, who is better qualified to jump start the economy and whether taking more from succesful small businesses is the best solution. President Obama, whose last budget was defeated in the Senate 99-0 and the House 414-0, seems to think he is more qualified.
The return on equity analysis used in a private investment decision is trumped at the government level by existing obligations, mostly entitlements and political favors such as public works projects or government “investments” in Solyndra, Evergreen, Beacon Power, or other politically connected industries. Public works projects and government investments have a poor history of return on invesment. The notion that government collection and redistribution of small business owners profits has a multiplier effect greater than 1.0 is laughable.
When a business owner advocates for entitlement reform, the idea is based on experience in allocating limited resources, not so much the popular notion that this rich person is greedy and wants to hurt the poor or disadvantaged. The business owner would have much preferred to hire two new people to help the company grow. Government has always been troubled by poor stewardship of taxpayer money. “Good enough for government work” wasn’t conceived in a private business focus group: it’s been a job site joke for centuries.
After all the rhetoric is peeled away, the difference comes down to who can do a better job of providing an environment where people who can work are working: businesses, where competition demands accountability and improvement, or government, where politicians decide what to do with other people’s money. Consider this as the rhetoric is reduced to sound bites.
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