Higher tax rates are “hire” tax rates: Raising marginal tax rates on the rich should help create jobs for small businesses

by Alan Cohen

Federal_Income_Tax_Rates_in_the_US,_2009

In all the US economic and political debates these days, one of the primary claims of conservatives is that raising marginal tax rates on the rich – the percentage of tax the rich pay on their income in the highest brackets – will hurt job growth because many small business owners, who file taxes as individuals, will have to pay higher taxes and will thus have less money to hire new workers. The typical response of those on the left and center is to argue that the tax only affects net income, after deducting expenses like workers’ salaries, and the effect shouldn’t be that large. The left thus argues that whatever harms may befall the job market are minor compared to the benefit of increased revenue.

I think both sides are wrong and missing something important. Raising marginal rates on high income brackets should actually have the opposite effect: it should encourage small businesses to hire more. I am not an economist, and there are numerous empirical studies dealing with this issue, often reaching varied conclusions. The analysis here cannot compete with a solid empirical study, but given the lack of empirical consensus, I think it is important to point out the logical error being made based on economic theory.

Imagine you own a small business – a successful landscaping company, let’s say, with 20 employees. You make a substantial personal income, about $500,000 per year of gross income, after subtracting out all the various business expenses, including your employees’ salaries. You believe there is room for your company to continue to grow in your region – if you had more employees, you could generate more business. Under 2012 US tax law, your top marginal rate is 35%, and under 2013 law it is 39.6 percent. This 4.6% difference might affect your decision, but in order to make the example clearer, let’s assume that congress somehow manages to raise the future  tax rate on all income over $150,000 to 70%, and let’s compare that to the 2012 rate.

For the sake of argument, let’s suppose that you set aside $150,000 of your income as the minimal amount you want to take home for personal use, but for anything more than this you are debating whether to use it for yourself or expand your business, hiring employees at $50,000 apiece. Would you be more or less likely to hire more workers under current law, or under the new law?

Well, under current law you can take home most of the income you make over $150,000 – after subtracting out ~35% for taxes of this $350,000, you would have $233,699.50 left that you could use to buy a big house, a new Ferarri, send your kid to Harvard for 4 years, or whatever you want. On the other hand, you could use all of that $350,000 (before tax) to hire seven new employees at $50,000 per year each. That’s your choice, or any combination of employees and that income.

Under the proposed new rates, on the other hand, you are paying 70% of the $350,000 in taxes if you decide to keep it. That leaves you just $105,000 for a much less fancy Ferarri or a mere two years at Harvard for your kid. But, since the $350,000 could also be used untaxed to hire employees, you can still hire all seven. It’s not necessarily clear what choice you will make, but if you wouldn’t have hired employees at the lower tax rate, you certainly won’t at the higher rate, whereas maybe you would have hired them at the higher rate but not the lower rate.

Averaged out over millions of small business owners like you, the cumulative effect of an increase in high marginal tax rates could be large. By increasing the tax rates (but only on personal income after expenses, not on the salaries paid to employees), we give business owners a stark choice: hire employees with your money, or give a big chunk of it to the government. It’s why the tax deductions for charitable giving produce so much benefit for charities: you can give all of an amount of your money to charity, or you can give a lot of it to the government and keep a bit for yourself. Raising rates should also help charities.

This principle seems so simple and basic that it’s hard to imagine exactly how it got so turned around in the political discussion, and why the left has not called the right out on it. But there you have it. Have I missed something? When anything seems this clear and straightforward, I have a nagging sensation that I’ve made some simple error somewhere. If so, let me know in the Comments section…

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