Breaking: A Serious Discussion in D.C.

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Publisher Todd Stauffer

Donna Ladd and I had the good fortune to attend a meeting a few weeks ago at the White House as part of their initiative to reach out to small businesses around the country. While discussions about innovation, technology and immigration were all on the agenda, this meeting, in late November, was overshadowed by the topic of the looming "fiscal cliff."

We weren't there as media, but rather as small business owners, with the same general concerns that the other 50 or so folks around the large conference table, with various political leanings, wanted to share with the White House.

It was a remarkable experience. Imagine yourself in any room in Washington, D.C., where honest--sometimes emotional--discussion takes place among 50 or so businesspeople who are clearly from different backgrounds and parties and have different ideas about how things need to get done. People who work at the White House listened to all of us and tried to answer concerns, sometimes more successfully than others. Other people in the room responded with their own perspectives, stories and point of view.

By the end of the day, deep discussion was taking place, with people seeing other people's perspectives and hearing other people's passion. As the meeting wound down, I think nearly everyone in the room appreciated the opportunity--and many probably felt a swell of patriotic pride at the undertaking.

We don't imagine that sort of thing happening in gridlocked Washington, D.C., but it did when I was there. And I applaud these folks at the White House for making it happen.

I say all that to say this--as a result, Donna and I have been thinking and talking a lot about getting the facts right on the "fiscal cliff," and we've had a unique opportunity to hear the thinking behind the White House's position on it. Let's look at some numbers.

The federal budget is cut up into three basic chunks--"discretionary" spending, which is 35 percent of the budget; "mandatory" spending, which is roughly 60 percent; and interest on the debt, which is about 5 percent.

Discretionary spending includes infrastructure, energy investment, and education, as well as spending on defense and homeland security.

In fact, about two-thirds of the discretionary budget is defense and security (including the State Department and FEMA)--it's over $800 billion.

The non-security spending is something a bit over $400 billion.

In the Budget Control Act of 2011, Republicans and Democrats agreed on $917 billion in spending cuts (over 10 years); as a result, non-security discretionary spending is now actually pretty darned low on a historical basis. That's cuts to Health and Human Services, HUD and the Justice Department, for instance, both this year and ongoing.

If there are going to be more cuts--and there will be, as the White House's goal is to get the budget deficit to within 3 percent of GDP--we're going to have to cut security (including defense) and/or mandatory spending, such as entitlements.

President Obama has said that both are on the table, although he doesn't support cutting defense as much as the Simpson-Bowles recommendations.

There are strong signs that Obama will support some entitlement reform, even though the base of his own party is against it; Obama also hasn't rejected raising the age for Medicare coverage.

While we've been doing a fair bit of cutting, we've largely kept in place the tax rates of the 2000s, which means we're sitting at low revenue rates, a little over 15 percent of GDP.

During the Reagan administration. it was over 18 percent; over Clinton's two terms it averaged 19 percent. The Obama administration's solution is one you've heard--keep Bush-era rates for lower earners, but return to Clinton-era rates for taxable incomes over $250,000.

It's the tax increase that got the most heated discussion among business owners at our White House meeting, and for good reason. As you may recall from the election, conservatives like to call any tax increase on people who clear over $250,000 in a year a "tax on small businesses." That's a wild overstatement, but there's a grain of truth in it, which I call the "Schedule C doughnut hole."

First, the overstatement: Remember, it's "net" income, not gross receipts. (Most businesses have to generate in the millions in gross receipts to make hundreds of thousands in taxable profits.) Plus, it's a marginal tax, so only the taxable dollars over $250,000 are taxed at 3 percent more when you reach the new bracket; dollars below that amount are taxed at the lower rates. So the hit only really kicks in when you're reporting some serious net income.

Now, the grain of truth: The tax code currently has a hole in it that affects small businesses that are organized as LLCs or S corporations. Because these businesses report their business taxable income on Schedule C of their personal tax form, the owners can be liable for taxes on money that they don't actually receive from the business. (If your business has $50,000 in net revenue at the end of the year, but you want to buy a $50,000 truck next year, you may still be liable for taxes on that $50,000 on your personal 1040 in April, even though you didn't get the cash in your personal account.)

The answer from the White House folks? That's a tax reform issue, not a tax rate issue. And they're right; if you and your company report enough net income, then being taxed at a slightly higher rate doesn't really change the problem that you're being taxed on money you didn't receive regardless of which rate is in place.

So this is where the rubber meets the road. First, we need to get the fiscal cliff averted--and the recession that would come with it--and we need to raise revenues as a percentage of GDP to at least Reagan-era levels. That means more tax revenue, which means higher tax rates. (That's the "math" Obama keeps talking about.) Leaving the rates low doesn't really do enough for the small business doughnut hole to solve that problem, anyhow.

Then, there's an important next step in 2013--we need to lean on Democrats, Republicans and the White House to pursue corporate tax reform in the new year, including reform to address the doughnut hole affecting small businesses that net more than $250,000 a year.

Agree? Call your congressional representatives and tell them to raise rates now and reform business taxes next year. That's what's best for the economy and for the small businesses that drive it.

Comments

RichardASunCFA 1 year, 8 months ago

Your Comment: "Most businesses have to generate in the millions in gross receipts to make hundreds of thousands in taxable profits."

Basically you are pointing out correctly that taxable net income is often 5-15% of gross revenue (but varies by company and industry, a few industries and companies bring much higher percentages to taxable income ).

The vast majority of the ownership of start ups funded by individuals is held by individuals already in the highest tax brackets before the company turns a dollar of profits.

The SEC limits the amount of funding that can be taken from individual investors who are not Accredited Investors, i.e. "rich". The SEC defines Accredited Investors as individuals with a net worth of a $1 million or annual net income of $200/250K+. For them, the first dollar of taxable income of the smallest business is hit by the rate increase.

Their overall return on the investment and the decision to invest in a new business is also reduced by the cap gains tax increase of 3.8% from Obamacare and the tax increase we can expect in the near future as part of entitlement reform. Can you imagine a reduction in entitlement spending without another round of tax increases on the "rich"? That would be the the third round of tax increases on the "rich".

It maybe more accurate to say that the marginal tax increase affects the marginal investment decisions of investors in job creators rather than to generalize it as a tax on small businesses--not as good a sound bite though. It still makes collateral damage of the creators or funders of most new jobs in this country.

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tstauffer 1 year, 8 months ago

@Richard -- I understand what you're saying and don't dispute the internal logic of your argument, but I would submit that you're making the argument like a financial planner, not an entrepreneur. If the investors are looking at such low-margin businesses that 3-4 more points of taxes on their investment income would keep them out of the market completely, then maybe those aren't the best investments in the first place. (Sure, there are exceptions, like the newspaper business [grin], but then at that point you're probably investing for something other than pure $$ returns.)

If our well-healed folks are making good investments -- for whatever reason this high-income individual would care to participate in them -- then you're arguing that making another $100,000 in relatively passive income isn't worth the extra $4,000 you'd have to pay in taxes. Tough to swallow. (Not the mention that it's your opportunity to pay down some of those billed we've accrued as the strongest nation in the world. :)

Also, we're nowhere near historical highs on these tax rates and the capital gains tax is pretty ridiculously low; you could argue that the gap between the top income tax rates and the capital gains rate actually created some of the problems that lead to the Great Recession. On a macro level it's logical to bring revenues up to 17-18% of GDP and one place to start is by restoring to rates that we've seen and succeeded with in the past.

And, finally, Richard, you might be able to speak with expertise to some of the history here -- it seems to me that one of the reasons we have S-Corps and LLCs was to avoid double-taxation of C Corps... people seem to be forgetting the benefits of this arrangements as we argue at the margins; it's hard to make a case that people will suddenly stop investing in all of this "job creator" activity (which is only a "job creator" for as long as there's a market for the product or service being offered) because of the pass-through income. Not that it isn't a problem -- it's something that needs to be dealt with. But it's not as much a rate problem as a tax reform (and/or corporate structure) problem.

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