Public Policy, Economics and Entrepreneurship: July 2009 Archives

The US is not the only country faced with crippling effect of higher tax rates.

The TaxPayers' Alliance in the UK has just released a new report by Jonathan Scott and Matthew Sinclair that shows that the new 50p tax rate will push the total tax burden on high earnings to crippling levels and argues that will mean fewer entrepreneurs and jobs.  The report argues that government tax changes, which will raise the marginal tax rate, will reduce the incentives to become an entrepreneur.

The UK did not benefit significantly from the entrepreneurial boom that led up to this recession, according to the authors.  They state that business formation in the UK grew only 0.3% from 1997 to 2006.  With these higher tax rates, it is doubtful that entrepreneurs will be leading the way with new job creation in the UK any time soon.

From the report:

When entrepreneurs earn a large amount of money they will often earn
substantial amounts above the various tax thresholds, save and invest that
money then eventually pass it on to their children. That money is therefore
taxed repeatedly before it is spent and winds up facing a very high marginal
rate:

• Under the present tax system that rate is around 90 per cent.
• With the proposed 50 per cent top tax rate, the marginal rate facing successful entrepreneurs could rise to 92 per cent. That means this measure has taken 20 per cent of the money entrepreneurs are left under the present 40 per cent top tax rate.
• Even if entrepreneurs take their initial reward as capital gains and benefit from the Entrepreneurs' Relief, they will still face a marginal rate of 86 percent.

This week's topic for Forbes magazine's America's Most Promising Companies comes from Brett Nelson, Entrepreneurs Editor at Forbes.  He asked us to comment on the following:

Health care headlines have dominated for more than a week now. And yet the dialogue still seems many steps removed from how all of these proposed changes will help/hurt small, growing businesses.

This blogger has done anything but ignore the impact of socialized medicine on small business.  My post yesterday stressed again the negative impact it would have on job creation due to increased costs and the healthcare mandate that would be faced by any small business with over 25 employees.  I have also warned of the negative impact that higher marginal tax rates necessary to pay for national healthcare would have on entrepreneurs -- on their start-up rates, their exit plans, and their growth strategies.

The interesting thing to me is the steady chorus of small business owners who say that they want nationalized healthcare. They seem to be taking the short-sighted perspective that this will take one more hassle off their plates.

Here is my warning to them.

There is an even greater danger to supporting this plan.  It is one more step to diminish our property rights.  Nationalized healthcare would be yet the next step down the road to reaching the tipping point of moving from a capitalistic economy to a socialized economy.  It is one more step toward moving basic property away from private ownership to becoming public goods to be doled out by bureacrats and politicians.

Ultimately entrepreneurship is based on a system of property rights and liberty.  The move toward socialization of healthcare -- and banking, and manufacturing, and insurance, and mortgages -- is eating away at the foundations of entrepreneurship like a cancer.

The healthcare debate, especially as it will impact small business, is all the buzz in Washington and around the country.

 

Rita Gunther McGrath has a well argued post at her blog about the impact of higher taxes needed to pay for socialized healthcare and the inevitable regulatory burdens that it will create.  Here is an excerpt:

 

Well, the first predictable consequence is that an awful lot of entrepreneurial energy is going to be spent, not productively, but unproductively, as small business people and those falling into the higher-tax categories spend their time not producing new innovations but figuring out how not to fall into the maws of increased tax and regulatory burdens.  Following right on that as a predictable consequence is that those who are able to do so will do business in such a way that they don’t fall into the higher-taxed categories.  Rather than pay individual rates, small businesses will incorporate and pay the lower 35% corporate rate.  Further, get ready for the new conglomerates - thousands of businesses employing exactly 24.5 people, all interconnectedly doing business with one another rather than falling foul of the over 25 employee stricture.  And with small business growth having led us out of most recessions in the past, get ready for this sector to add jobs far more slowly and with far greater caution than it had previously - a big blow to an economy that desperately needs a vibrant and growing small business sector. 

 

Thanks to John Wark for passing this post along.

 

The NFIB has dedicated their monthly Top 9 Questions to the topic of healthcare.  Here is what they serve up this month:

 

1. HEALTH INSURANCE - REASONS FOR OFFERING EMPLOYEE HEALTH INSURANCE - Please tell me if the following is a major reason, minor reason, or not a reason why your business OFFERS a health insurance plan to your employees?  It helps employee recruitment. (Vol. 3, Iss. 4, Q#5A.)

 

2. HEALTH INSURANCE - REASONS FOR OFFERING EMPLOYEE HEALTH INSURANCE - Please tell me if the following is a major reason, minor reason, or not a reason why your business OFFERS a health insurance plan to your employees?  Competitors offer it. (Vol. 3, Iss. 4, Q#5G.)

 

3. HEALTH INSURANCE - REASONS FOR OFFERING EMPLOYEE HEALTH INSURANCE - Please tell me if the following is a major reason, minor reason, or not a reason why your business OFFERS a health insurance plan to your employees?  It's the right thing to do. (Vol. 3, Iss. 4, Q#5H.)

 

4. OWNER HEALTH INSURANCE COVERAGE - As the owner of this business, how do you obtain health insurance coverage for yourself?  Do you obtain it:?  (Vol. 3, Iss. 4, Q#1.)

 

5. HEALTH INSURANCE - CONSULTING EMPLOYEES - What was your general sense of what your employees most wanted in health insurance?  Was their priority:?  (Vol. 7, Iss. 3, Q#12a.)    

 

6. DROPPING EMPLOYEE HEALTH INSURANCE - Though you don't offer it now, did you offer employee health insurance at any time in the last three years? (Vol. 7, Iss. 3, Q#1b.)

 

7. HEALTH INSURANCE - REASONS FOR NOT OFFERING EMPLOYEE HEALTH INSURANCE - Please tell me if the following is a major reason, minor reason, or not a reason why your business does NOT offer health insurance to your employees?  Employees prefer wages and/or other benefits. (Vol. 3, Iss. 4, Q#13A.)  

 

8. HEALTH INSURANCE - REASONS FOR NOT OFFERING EMPLOYEE HEALTH INSURANCE - Please tell me if the following is a major reason, minor reason, or not a reason why your business does NOT offer health insurance to your employees?  Business can't afford it. (Vol. 3, Iss. 4, Q#13F.)    

  

9. EMPLOYEE HEALTH CONDITIONS AND JOB PERFORMANCE - How many of your current employees do you believe have had their job performance adversely affected by substantial excess weight or a weight-related condition?  (Vol. 4, Iss. 3, Q#13.)

 

Thanks to Denny Dennis and the folks at the NFIB Research Foundation for their good work on this project.

Finally, check out the Employer Health Benefits, 2008 Annual Survey Kaiser Family Foundation at www.kff.org, which has excellent statistical information on health care with an emphasis on small business.    

Don't let the bump in the road in the Senate lull you into assuming that socialized healthcare is in trouble.  That train is still heading down the tracks.  And no matter how you look at it, the model of socialized healthcare now being pushed through will not be good for small businesses and their employees.

First, it will have a huge impact on employment.  There was a very telling e-mail posed at Hugh Hewitt's website (thanks to John Wark for passing this along).  Here is an excerpt:

Now Obama-care is proposing an 8% payroll surtax to finance mandatory healthcare?!  This is INSANITY.  Restaurants are built on after tax cash flow business models of less than 5% (which mind you has already been chipped by about 2% for min wage increases and price discounting to maintain traffic during a recession has hurt profits as well).  Given payroll represents on average 25% of a restaurant businesses sales, an 8% surtax represent another 2 % hit to the bottom line!  The senate version is almost as bad.  And don't let the small business exceptions fool you as restaurants are VERY labor intensive, and even a single small restaurant operation typically employees 20-30 people- practically every restaurant in America will be impacted by the mandate.  Given that most small business restaurant operators survive on scale (2-10 locations) and again at very low margins, the small business exceptions will provide no relief for the those in the restaurant industry who provide the majority of jobs.

The incremental cost of adding that 25th employee under the proposed mandate will create a permanent cap on employment growth for many small firms.  Some will bite the bullet and add that 25th employee and face the huge burden of healthcare mandates, but many will opt not to grow.  Believe me, many entrepreneurs already are hesitant to add employees due to the hassle of payroll requirements.  This will be yet one more bureaucratic roadblock to employment growth in small business.

Then there is the whole quality of care concern for employees covered under these plans.  Take a look at this graphic, which shows the average wait time for our neighbors to the north in Canada.  Anyone who argues that quality and speedy access to healthcare are not critical factors for worker attendance and productivity are fooling themselves.  Just ask any small business owner how important having a healthy workforce is to overall business performance.

As an advocate of fundamental restructuring of our healthcare system, I have been told that I am naive -- that incremental change is the only practical and politically possible way to create healthcare reform.  Well, the system is indeed headed for fundamental restructuring right under the noses of the compromisers out there who have been coopted into a false debate.  But, it is the polar opposite of the free market restructuring that some of us had in mind.

In my column in this week's Tennessean, I offer a path to help create a true bailout for small businesses:

Each year during the 20 years leading up to this recession, small businesses generated 75 percent to 80 percent of all new jobs. This was a remarkable transition in our economy that created a fundamental shift in employment.

The Fortune 500 went from employing about 20 percent of all American workers in 1980 to less than 5 percent by around 2000. Small businesses grew to make up half of the gross domestic product and half of all employment during this same period.

The most recent employment report from ADP, a human resources outsourcing firm,showed that 177,000 small business jobs were lost just last month. Joel Prakken, who compiles the data, said:

"Despite a notable improvement over the first three months of the year, when monthly losses averaged 260,000, employment among small-size businesses is likely to decline for at least several more months. Since reaching peak employment in January 2008, small-size businesses have shed nearly 2.3 million jobs."

Just in the past 18 months, small businesses shed as many jobs as the Fortune 500 did during the entire decade of the 1980s.

History has shown us that it has been entrepreneurs who have led us out of almost every previous recession. However, most experts now agree that a large number of entrepreneurs need an infusion of cash if we are to have any hope of them leading us to an economic recovery.

The simplest and most direct way to do this would be through implementing lower tax rates. This has been shown in studies from around the globe as being a strong stimulus for new business formation and growth.

But rather than enact tax cuts, it now looks like we can expect some form of an expanded small business loan program funded by tax dollars as the likely choice for any small business financial bailout.

The downside of this strategy is that not all the funding ends up in the checkbooks of business owners. Instead, it adds additional governmental costs associated with distributing loan funding and monitoring any new loan program. Since many of these loans will be quite risky, expanded government-backed small business lending also exposes the taxpayers to future additional costs due to the risk of a high rate of default.

A second challenge facing many entrepreneurs is increased regulation. Governments all around the world are cutting the red tape that affects small businesses to try to spur entrepreneurial activity. But in our rush to re-regulate business in the U.S., small employers are beginning to feel the effects of these expanded government regulations.

This will certainly increase costs to small businesses, making earning a profit that much more of a challenge.

The best small business bailout would be for government to do less, not more -- take less in taxes out of the pockets of entrepreneurs and impose less regulation. However, I just do not think that such an approach can be found anywhere in Washington these days.

The standard approach for funding any new program coming out of Washington these days is to "tax the rich."  Take for instance the plan now in play to fund socialized healthcare.  This approach, although appealing for sound bites and bumper stickers, will soon have a devastating impact on our economy.  A return to a much more progressive tax structure will inhibit job creation for years to come.

Let's start with who creates jobs in our economy.  For the past twenty years it has been overwhelmingly entrepreneurs -- over 75% of all new jobs came from small businesses during this time period.

One of the incentives to take the risk to create a new business is to build wealth.  Most entrepreneurs take a significant hit on their short-term income potential, but are willing to do this with the hope that at the back end their will come a big payday as a reward for their hard work and personal risk-taking.

When an entrepreneur sells his business, we must remember that much if not all of the proceeds from the sale are treated like ordinary income, which like all profits from the business pass directly to the owner.

With all of the "soak the rich" plans in place to pay for our new found fascination with socialism in the US, I would not be shocked to see marginal rates soon top 50% or more.  Maybe not immediately, but as the true costs of all of these new programs become real the answer to soaring deficits will undoubtedly be to tax the wealthy even more.

Remember, capturing the wealth out of a private business is usually a one time event at the time of the sale of the business.  These are almost always asset purchases that result in a huge one-time bump in income.

With higher marginal rates, we will see fewer entrepreneurs willing to take the risks and put in the effort to launch new ventures.  In fact one study I have used often in class suggests that for every one percent increase in marginal tax rates we see a 1.4% decrease in start-up activity in the economy.

So in the frenzy to pass program after program that will be paid with higher taxes on "the rich", you can bet that we will see fewer entrepreneurs starting businesses that would create the jobs we need to revitalize the economy.  On top of that, there will be fewer of these one-time "rich" people who get a one year bump in income when selling a business.  This will create tax short-falls that will only further escalate the deficit.

I have been arguing for some time that it is time to fundamentally restructure our immigration policy in this country.  We need to create a path for aspiring entrepreneurs to come in and help fuel our entrepreneurial economy.  A new study from the Office of Advocacy of the SBA reinforces my point.

The study authored by David Hart, Zoltan Acs and Spencer Tracy found that sixteen percent of high-impact, high-tech firms have at least one immigrant founder.  Although these firms are concentrated in states with large immigrant populations, in most other respects they resemble high-impact, high-tech firms founded by native-born entrepreneurs.

Moreover, these immigrant entrepreneurs are highly educated and appear to be strongly rooted in the United States.  Roughly 55 percent of the foreign- born founders hold a masters degree or a doctorate.  In addition, they are more than twice as likely as native-born founders to hold a doctorate.

Furthermore, 77 percent of the foreign-born high-tech entrepreneurs are American citizens and, on average, they have lived over 25 years in the United States.  Two-thirds of them received their college degrees here, as well.

"Immigrant entrepreneurs clearly contribute a significant amount to our country's cutting edge high-tech firms," said Shawne McGibbon, acting Chief Counsel for Advocacy.  "This report outlines these contributions and delivers important new data about immigrant entrepreneurs."

According to the NFIB, the current recession has been harder on small business profits than any time over the past 35 years.  And profits slipped again this past month.

"When profits are bad, like now, small business owners cannot reinvest, except to replace things," said Bill Dunkelberg, NFIB chief economist.

Plans to make capital expenditures fell again to 17 percent, continuing a run of historically low readings.  One consequence of this has been a huge reduction in inventories, with record numbers of firms reducing their inventories to line up stock with lower customer spending.  In June, the net percent planning to add to inventories over the next three months was negative 6 percent, indicating further planned reductions.

A major cost-cutting activity has been focused on one of the largest costs - labor.  Over the past six months, owners have reduced employment at a record pace.  Plans to expand employment got a boost in June (up four points to a net negative 1 percent of firms planning to hire in the next three months). The number of firms with job openings to fill increased two points to 11 percent in June.  However, small employers continue to hold wages and other employee compensation in check, with 11 percent of owners raising compensation while 12 percent reduced it, the worst showing for a "raise" in survey history.

Expanding small business loan programs is not the answer to this problem.  It is time for policy makers who support free markets to step forward and push for income tax cuts.

Since most of these small businesses are pass through entities for income taxes, cutting taxes will have an immediate impact of profits, which will alllow them to reinvest, build inventories, and begin to hire again
 

From the Wall Street Journal:

The Obama administration is discussing ways to expand assistance to struggling small businesses, but there is some disagreement among top officials over the best approach, according to people familiar with the matter.

Washington has it half right -- we need to get some cash in the hands of small businesses to help stimulate the economy. 

The easiest and most effective way to achieve this would be an income tax cut, since most small businesses are flow through entities (the businesses pay no income tax and the profits flow directly to the owners to pay this tax as personal income).  This would put the maximum amount of working capital in the hands of business owners -- no overhead cuts for the bureaucracy to collect, distribute, and track the money.  It would let the business owners keep more of the money they are creating through their efforts to grow their ventures.

Instead, those in power now in Washington want to play a much more active roll in the process.

The two ideas being bantered about are to:

1. Have the government directly underwrite small business loans
2. Use part of the bailout money as targeted funds for banks to lend to small businesses

Both of these approaches  expose the taxpayers to too much risk.  Both of the plans also have the potential of creating a small business bubble in the economy.

However, I am reasonably certain that one of these approaches will be implemented.  Both plans are consistent with the new paradigm in Washington, which views all property as ultimately the people's collective property to be doled out as politicians and bureaucrats see fit.

Tax cuts are policies for those who view property as an individual right.  That paradigm seems to be rather scarce these days in Washington.

Blogger James Pethokoukis offers five alternative stimulus plans to the one we are getting from Washington right now.  His alternative plans, all of which would spend about what is being spent on the current plan, include:

1. An investment stimulus plan that would cut capital gains and corporate income taxes to stimulate investment.
2. A worker stimulus plan that would give workers a massive tax cut.
3. A couple of variations of a housing stimulus plan that would support creating a large pool of 30 year fixed rate mortgages.
4. A deficit hawk stimulus plan to cut the tinder box that is about to ignite inflation and help calm bond markets.
5. A do-nothing plan, that would roll back all of the stimulus plans already enacted.
   

I vote for a modified "Do-Nothing Stimulus Plan."  I would opt to not only do nothing, but actually do a lot less.  By slashing government spending and programs we can not only cut the deficit, but hopefully give real tax relief, thus creating a long term, sustainable recovery. 

I know, I know, I can hear you now -- "Get out of your ivory tower and quit dreaming, Professor."  But, look how much of their agenda the socialist got done in only six months by dreaming big plans and then getting the right people in office.  It could happen.....

Scott Shane is at it again.  Shane is a professor of entrepreneurship at Case Western Reserve.  He is well respected in academic circles, but as of late has taken up the cause of dismissing the importance of small business in our economy.

Interestingly, he was chosen as one of the bloggers for the New York Times new on-line small business site called You're the Boss, where they say that he "writes about the economy from a small business perspective."

Here is what Professor Shane had to say about small business in an article at CNN Money:

From a societal point of view, if you have a group of people who do something that makes them happier but less productive (which the data support), and you aggregate that, then entrepreneurship is an economic drain. If the goal of the policymaker is to make everybody in your country happy, then let everybody start businesses.

But most policymakers seek to create jobs and promote growth. If that's your goal, you want to stop all these people from starting marginal businesses that don't go anywhere and devote the resources to encouraging high-growth companies. In terms of tax policy, for example, you could argue that the government should eliminate the home-office tax deduction - which doesn't differentiate between high- and low-performing businesses - and beef up R&D tax credits.

This does not sound like a voice of support for small business to me.  Not surprisingly, these and similar comments from him of late have created quite a buzz.

One of his favorite arguments is based on looking at various measures of rates of entrepreneurial and small business activity rather than absolute numbers and their true economic impact.  Here is a quote from his latest post at the New York Times blog.

Most Americans would like to believe that this country is getting more entrepreneurial over time. While I wish this were true, the data don't agree. Policy makers need to take a look at these data and acknowledge the pattern. More important, they need to understand why the rate of entrepreneurship is declining over time.

As I explain in greater detail in my book, "Illusions of Entrepreneurship" (Yale University Press, 2008), one reason is what one might call the Wal-Mart effect. Large, efficient companies are able to out-compete small start-ups, replacing the independent businesses in many markets. Multiply across the entire economy the effect of a Wal-Mart replacing the independent restaurant, grocery store, clothing store, florist, etc., in a town, and you can see how we end up with a downward trend in entrepreneurship over time.

No, Professor Shane, measures of actual entrepreneurship are not declining and it is still a vital force in the economy.  And if we don't turn loose small businesses, the recession will last even longer than it might otherwise.

It is clear that you are one of those who would love to steer and shape the economy from a policy viewpoint.  Please, just keep your hands off our economy and let free markets work!

Each and every year during the twenty years leading up to this recession, small businesses generated 75-80% of all new jobs. This was a remarkable transition in our economy that created a fundamental shift in employment.

The Fortune 500 went from employing about 20% of all American workers in 1980 to less than 5% by around 2000.  Small businesses grew to make up 50% of the GDP and 50% of all employment during this same period.

But rather than enact tax cuts, which is the best single stimulus for entrepreneurial activity in an economy, we are now obsessed with propping up the large corporations that have already seen their best days, and to artificially try to stimulate new industries that cannot exist one their own in the market without massive government subsidies (i.e., almost every business with any "green" theme).  And we are going to pay for all of this through higher income taxes and a whole new class of taxes created by Cap and Trade.

Our inattention to what really benefits entrepreneurial economic development has had a devastating impact on jobs.

The ADP Small Business Report showed that 177,000 small business jobs were lost in June of 2009. According to Joel Prakken, who compiles the report:

 

"Despite a notable improvement over the first three months of the year, when monthly losses averaged 260,000, employment among small-size businesses is likely to decline for at least several more months. Since reaching peak employment in January 2008, small-size businesses have shed nearly 2.3 million jobs."

In about eighteen months, small business employers shed as many jobs as the Fortune 500 did during the entire decade of of the 1980s.

A small business bailout cannot succeed if it is an interventionist approach by Washington as we have seen in their approach to the auto industry, the banking industry, and who knows what next.  We should not infuse tax dollars into targeted industries or businesses if we want to restart the small business job engine that created so much of our prosperity of the past 20 years. 

The best small business "bailout" would be for Washington to do less -- much, much, much less -- than it is doing now.  But, alas, I just do not think that such an approach is found anywhere in the paradigm of either political party in Washington.

James Pethokoukis who writes for Reuters offers an interesting analysis on who gets credit or blame for the economy going forward, and why:

It's not so much that a more negative forecast would have prevented Obama from spending large amounts of money, it's that he would have been forced to tilt the stimulus more in favor of tax cuts which work a lot of faster  than government spending (though both are pretty inefficient as "stimulus").

And Obama wanted to spend billions on his "investment agenda (healthcare, education, infrastructure), not tax cuts.  (And if he had spent the $2 trillion that some liberals wanted on stimulus, it surely would have crowded out the rest of his agenda, plus rattled the bond markets.) So he gambled that monetary policy would keep the economy from getting as bad as it has. And he lost. Did Team Obama purposely give a bad forecast, or did its old fashioned Keynesian approach merely lead it astray? Good question. Either way, it's the Obamacrats' economy now.