John McCain has to choose his words carefully when he attacks Barack Obama on taxes. This is what he said in the second presidential debate, back on October 8th: "Senator Obama's secret that you don't know is that his tax increases will increase taxes on 50 percent of small business revenue."
It's a curious locution, that "50 percent of small business revenue." But McCain has to use it, because, as we've pointed out in the space previously, the vast majority of small businesses would not see a tax increase under Obama. In fact, many of them would do better under Obama than McCain. Yet despite the certainty of an Entrepreneurial Agenda judgment, McCain persists in the raising the issue of the supposed small business tax burden under Obama. He said it again1 at the third debate, on Wednesday, which is how millions of Americans learned of Joe the Plumber.2
What McCain means, of course, when he talks about half of "small business revenue" facing a tax hike is that a small number of entrepreneurs generate the lion's share of revenue. And for those who fall into that group, McCain's argument may well resonate. Clearly many Inc. readers earn that half of small business revenues, and wariness toward Obama's tax plan has shown up in the Inc.com corner of the blogosphere. A month ago, David Mammano was the second of my fellow Inc.com bloggers to announce his reservations. "As a small business owner, Obama just lost my vote," he declared. "His tax plan is an assault on all S- Corporations and sole proprietorships."
If an S-corporation makes a profit of $300,000, the owner gets taxed on $300,000, whether the owner takes it al out or not. So let's say I only take $100,000 out of the company this year and the profits were $300,000, I still get taxed on $300,000. Everything flows down to the owner(s). So even though it looks like I personally made some major dough this year, that's only 1/3 true.
Currently S corporations face a top tax rate of 35 percent. Under Obama's plan, the rate would rise to almost 40%. And it might not stop there. Many Democrats in Congress have proposed making all small businesses pay a 50-plus percent tax rate. This would kill the entrepreneurial spirit in America, in my opinion.
David is hardly alone. Jay Goltz said pretty much the same thing back in August. If only it were true.
First, as David probably knows, when he puts the money he's earned back into his business, he gets a tax deduction. He can deduct the inventory he buys when he sells it. He can deduct the wages of new employees when he pays them. Under the Section 179 rules, he can normally deduct $125,000 of machinery and equipment in the first year. (In 2008, per the Economic Stimulus Act, the limit is $250,000.) In fact, unless David is buying a building or a business or an extraordinary amount of equipment, he can usually deduct most, if not all, of his investment in the first year.
The cost to him is really the time value of that money in that intervening period. To use David's $300,000 example, you're talking about the interest on the few thousand dollars difference between the tax bill under John McCain and the tax bill under Obama. If David could earn five percent a year on that money, then it's cost him about $332.3 As Tom Peterson put it at the Inc. 5000 conference in September, "If a two-percent change in your marginal tax rates really affects your business, then you don't have a business model."4
But let's look at the bigger picture. If the past is any guide, the economy is likely to perform better during an Obama Administration than a McCain Administration. Michael Kinsley (or his lackey) did the legwork on this one, in an article for Slate, complete with charts. He looked at seven economic indicators for each year from 1959 to 2007, found in the extremely official Economic Report of the President5, and concluded, "On average, in years when the president is a Democrat, the economy grows faster; inflation is lower; fewer people can't find a job; the federal government spends a smaller share of GDP, whether or not you include defense spending; and the deficit is lower (or -- sweet Clinton-years memory -- the surplus is higher). The one category that Republicans win is, unsurprisingly, federal taxes as a share of GDP. But it is no trick to lower taxes if you don't lower spending." When he went back and repeated the exercise with a one-year lag (to give credit, when appropriate, to the previous president), the results held. As Kinsley writes
There are no figures here about income inequality, or percentage of the population with health insurance, or anything like that. This exercise implicitly assumes that lower taxes are always good and higher government spending is always bad. There is nothing here about how clean the air is or how many children are growing up in poverty. The only point is that if you find the Republican mantra of lower taxes and smaller government appealing, and if you care only about how fast the economy is growing, not how that growth is shared, you should vote Democratic.
Assuming that a good economy is good for small business, isn't it better to pay slightly more in taxes for a more prosperous business than lower taxes on lower earnings?
Finally, if you would otherwise vote for Obama but for a tax proposal that compares unfavorably to McCain's proposal, you are trapping yourself in an ideological prism (not to say prison). The Bush tax cuts expire in 2010, and in 2011 all of the rates will revert back to where they stood before 2001. The only thing that could change that is an act of Congress, and as David notes, there are some in Congress who would like to raise the top brackets even more than Obama. Given the political landscape -- Democrats will dominate Congress -- and the politics of the economic landscape -- a taxpayer-funded bailout of financial institutions driven to ruin by executives who individually earned hundreds of millions of dollars -- the chances that a President McCain might actually persuade Congress to extend tax breaks for the wealthy are practically zero. If that.
In the end, this won't likely be a problem for Joe the Plumber, who until Wednesday was known as Joe Wurzelbacher. As it turns out, Joe is not a licensed plumber. He owes $1,200 in back taxes. And, according to the Toledo Blade, in 2006 he made $40,000 -- which means he'd likely get a bigger tax cut under Obama than McCain.
1Or tried to. What he actually said was, "Fifty percent of small business income taxes are paid by small businesses." That led Michael Kinsley (in a column fairly uncharitable toward small business) to retort, "Although I really should run this past Paul Krugman before going public, the evidence seems to suggest that as much as 100 percent of small business income taxes are paid by small business."
3It would actually be less, since he's taken $100,000 out of the business. Here's how I calculated it: Under the current rates, which John McCain would extend, David's $300,000 taxable income in 2008 would face incrementally rising tax rates, with the last $135,000 or so taxed at 33 percent. His total tax bill would be $84,751. Under Obama's plan, that 28 percent tax bracket would rise to 31 percent, and the 33 percent bracket would go to 36 percent. The total tax on $300,000 would rise to $91,385. The difference in tax is $6,634. Five percent of that is $332.
4The whole "S-corp" argument, incidentally, is basically bogus. Small pass-through businesses aren't treated any worse than any other investment, and in many cases are treated better. If David's firm were a C-corp, it would still have to pay taxes on income it planned on reinvesting. On $300,000, that tax rate would be 39 percent. As a couple of CPA friends (actually, my mother and brother) point out, if he took that money out and invested it in someone else's business -- that is to say, bought stocks -- he wouldn't get a deduction for that, either.
5The report is compiled by the Council of Economic Advisors.