Small Businesses Can’t Drive Job Growth if They’re Saddled With Higher Taxes

With high unemployment rates continuing to plague the nation, there has been a renewed federal focus on the “engine” of economic recovery — small businesses. The president has pledged to crack open credit markets to help these struggling enterprises grow and expand hiring. But the real remedy for small business stagnation is much simpler: The president and Congress must reject any and all health care reform proposals that will end up soaking small business owners.

The most immediate concern of small businesses is that many of them have been conveniently lumped in with “rich” Americans filing personal tax returns with net income greater than $250,00–$350,000. These are the taxpayers who will incur surtaxes and other indirect tax increases in order to finance coverage for the uninsured.

As it turns out, more than 2.5 million personal income tax filers with incomes of $200,000 or more declared income from farms, businesses, partnerships, or “S corporations” in 2005 (the latest year for which we have data). Of these entities, almost 2 million had net business income that was taxed as personal income. Lurking among these high-income filers are numerous S corporations, including businesses in the “Education, Health and Social Assistance” industry (an IRS classification). An IRS study of 1999 filings by S corporations (the latest available) reported that S corporations in the educational services category generated more than $645 million in net income; those devoted to health care and social assistance generated another $7.6 billion. Among the businesses in this latter category are virtually all of the private medical practices in the United States. In fact, federal tax initiatives aimed at stimulating small business employment have led a vast number of small businesses to incorporate as Chapter S entities.

As a Chapter S corporation, the net income of the business passes directly through to its owners for tax purposes. At the end of each tax year, this income is divided up and reported on each owner’s personal income tax return. These owners tend to be actively engaged in the business — doctors who provide patient care, for example — rather than passive stockholders.

All of the net income is taxed in the year during which it is earned, whether it has actually been distributed to owners or is retained by the business. Why would businesses retain earnings? The answer is simple: To avoid the vagaries of the small business credit market, many retain earnings to self-finance the acquisition of new plant and equipment. Small businesses that fill highly specialized market niches often require highly specialized equipment. In the case of my OB-GYN, a 3-D mammography machine that costs $500,000 promises earlier detection of breast cancer and lower mortality. Is this the type of collateral that outside lenders truly wish to loan against? And what about the $150,000+ electronic medical records system that Medicare will first encourage (through small grants) and then foist upon my OB-GYN by 2012? Sure, there are accelerated depreciation opportunities, but unless there is 100-percent depreciation during the first year of use, self-financed capital expenditures must be spread out over several years.

Clearly, increasing personal income tax rates to finance health care reform will have a depressing effect on small business investment and growth. Along with this, there are more subtle tax implications for small businesses in the current health care proposals. Take, for example, the plan to tax Cadillac employee health care plans. Businesses with a small number of employees tend to pay substantially higher medical insurance rates than large, self-insured corporations. It is not unusual for a small employer to pay an annual premium of $22,000 or more for family insurance coverage, with a $500 deductible and a 10-percent copayment. Any dollar cap on the tax deductibility of employer-provided health insurance would likely snag a disproportionate number of small businesses. The end result would be to increase the tax liability of small businesses, putting them at a competitive disadvantage relative to large companies. This disadvantage would be further exacerbated if those who are happy with their self-insured policies win their battle to be exempted from most of the insurance regulations included in the current federal reform proposals.

A more recent proposal that would negatively impact small businesses is the one that finances health care reform by increasing payroll taxes. At least some of these taxes will be passed backward to small business owners, especially those who are at a competitive disadvantage, relative to large corporations, when it comes to hiring.

Finally, many small businesses struggle to provide their employees with some type of health insurance. By and large, however, this coverage is much less extensive than the plans offered to employees of large self-insured companies, at least in part because of the higher cost of providing coverage to a small group. Should the minimum benefits package dictated by Congress be richer than what small businesses can reasonably offer, those business owners would be forced into a “pay-or-play” scenario that would undoubtedly raise their costs and reduce their competitiveness.

To promote the true survival and growth of small businesses, the first step to take would be to see to it that these companies are not saddled with higher tax burdens as a result of health care reform. The second thing would be to focus less on policies that encourage “easy credit” (isn’t this what got us into our current financial mess?) and more on policies that create incentives for small business owners to invest in themselves. Rather than increasing the tax rate on the net income of S corporations, why not instead exempt retained earnings from taxation altogether? In this way, policymakers would create a much needed incentive for small businesses to self-finance their capital needs and resume their historic role as the engine of employment growth in our economy.

Susan K. Feigenbaum is a professor of economics at the University of Missouri–St. Louis.