Raising Tax Rates on Small Businesses is Not a Smart Strategy

Business First published my "Guest Comment" today on the subject of raising taxes on small businesses (click here). The text of the article follows:

On the surface, raising income taxes on individuals making more than $250,000 seems reasonable to many people (especially those making less than $250,000 per year).

When politicians talk about these higher earners, they paint the picture of the public company executives making millions of dollars per year.

However, I want to discuss another class of people for whom raising taxes will have a negative effect on our economy. This is the small-business owner.

Many small businesses are organized as pass-through entities such as S corporations or limited liability companies. The profits from these businesses pass through to the owner’s individual income tax returns.

As such, many of these small businesses will be caught up paying higher tax rates under tax schemes currently being proposed. This will have two possible negative effects.

Capital for expansion will decline

First, capital for business expansion will be decreased.

About 40 percent of the income generated by S corporations and limited liability companies goes toward paying income taxes. In the majority of cases, most of the other 60 percent goes toward reinvestment in the business.

This usually takes the form of hiring new employees, buying new equipment and expanding into new business areas.

If tax rates go up, businesses are going to have less money to reinvest in their business growth. In this poor economy, we should be doing all we can to encourage small businesses to hire people and expand their operations.

Owners will be encouraged to ‘coast’

Second, small-business owners might “coast” and not work as hard.

I have talked with a number of small-business owners about the possibility of tax increases. Many of them have an interesting perspective on this.

Small-business owners as a group generally have a natural instinct to grow and expand their companies. Of course, one key benefit of doing this is to make more money.

However, there are downsides to growing a business. These include risk, stress and time. Actively expanding a small business involves significant risk that the expansion will fail.

This, and the worries that accompany business growth, usually cause significant stress on the business owner. And, of course, any efforts beyond the norm are going to take more of the owner’s time.

Owners could scale back

A disturbing number of small-business owners are telling me that they are going to “kick back” if tax rates go up. They are going to maintain their businesses at a level adequate to support their families — but no more.

If tax rates are going to increase disproportionately as taxable income increases over a certain level, why take the risk and incur the stress of growing their business beyond current levels?

In fact, I think some of them actually are looking forward to having a legitimate reason to “coast” for a while. This is not the attitude that our tax policy should encourage.

Thus, increased tax rates on small businesses are likely to create incentives for their owners to not expand their operations and may even cause them to scale back.

And that’s not a smart strategy in these challenging economic times.