Joe the Plumber, Obama’s Tax Proposals, and Small Businesses

By :: October 20th, 2008

by Len Burman and Eric Toder

Poor Joe the Plumber has become a political metaphor: something no one ever wants to be. As we all know by now, based on his actual (rather than aspirational) income of $40,000, Joe would get a slightly bigger tax cut under President Obama than President McCain.

But in one sense, even though the real Joe doesn’t own a business, most small business owners, like Joe, also have very modest incomes. Based on a sample of individual income tax returns, TPC finds that among tax units that receive most of their income from their own business, a partnership or a farm (reported on schedules C, E, or F), more than half have income below $30,000 and 80 percent make less than $100,000. (Table T07-0206)

The vast majority of small businesses would not be affected by Obama’s income tax increases. Among those that receive at least half of their income from a business or farm, 335,000 (2.7 percent) are in the top two tax brackets that are targeted for Obama’s tax increases. (Table T08-0164) Among tax units with any income from a business, 663,000 (1.9 percent) are in those tax brackets. Clearly, most business owners are safe from Obama’s individual income tax increases.

The individual income tax return data do not provide a precise picture of how taxes affect “true” small business owners. Some people who report business income on their tax returns are not really self-employed and some small businesses are “C” corporations that pay corporate instead of individual income tax on their business profits. Many people report some business income from freelance activities while they are full-time employees. Members of corporate boards, for example, report their compensation for that service on schedule C of their individual tax return. Partners in many law firms, accounting firms, medical practices, and Wall Street hedge funds also report business income rather than wages, as do people who receive rents or royalties from investments in real estate and oil and gas partnerships. All of these factors overstate counts of small business owners based on individual income tax return data. On the other hand, some small businesses are organized as taxable corporations (C corporations) and pay out all or most of their income as compensation to their owners to minimize corporate tax. Despite these caveats, it seems likely that relatively few taxpayers who are small business owners will be affected by increases in the top two individual income tax rates.

For more on this, see factcheck.org’s report.

8Comments

  1. Anonymous  ::  7:39 pm on October 20th, 2008:

    Could you please point me to data that correlates number of workers employed by the small business to each bracket reflected in Table T08-0164?

  2. Anonymous  ::  5:35 pm on October 24th, 2008:

    I was the person who posed the original question regarding whether anyone had correlated the number of small businesses with “higher” income (presumably subject to Obama's tax increase) and the number of people employed by those small businesses.
    I am particularly focused on how a small business (especially, one that has borrowed in order to purchase or grow a business) will respond to a tax increase. Admittedly, according to Obama’s website, the business has to record at least $200k in net income to see a tax increase. But how many of those small businesses reporting at least $200k in taxable income employ other working Americans? And, recognizing that repayment of debt must be made from after-tax dollars, how will a small business with fixed debt obligations deal with a reduction in after-tax cashflow?
    They will deal with it logically. If they don’t have enough cash left over (after paying higher taxes) to meet debt obligations and expenses, they will cut some costs to ensure that they can. The most variable cost to a small business is payroll.
    If the small business is lucky enough to not have to undertake cost-cutting, they will undoubtedly find it necessary to delay hiring new employees as they grow. And, in a prolonged, recessionary environment, that day may be long in coming.
    I was amused by one poster’s response that “…hiring new employees lessens the tax burden of the proprietor … In fact, it may lead to expansion as business owners expand to get the same take home pay”. I don’t know of any small business owner (disclosure: I am a co-owner of a small business) who has been waiting for just this opportunity (a tax increase!) to kick-off an expansion plan. You can bet, that with rare exception, they are thinking every day, of every way to grow their business. Increasing the tax burden can only reduce what after-tax cashflow they have to invest in growth. And, as for adding employees in order to get a tax deduction?…nobody who made a practice of investing a dollar for a thirty-nine cent return ever stayed in business very long.
    So, back to my question…
    How many individual taxpayers making $200k, or more, employ workers other than themselves? And, how many workers do they employ?
    Urban-Brookings Tax Policy Center has prepared a schedule (http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=1610) of the number of taxpayers with business income (Sched C, E, or F) that is greater than 50% of their taxable income (specifically AGI). This schedule shows approximately 8.8mm taxpayers that fall into this category. The vast majority (65%) reflect less than $50k in total (business and other) AGI. The schedule shows only 900k individuals with AGI greater than $200k.
    To be fair, using this taxpayer criteria as a definition of a small business has its holes, as readily admitted by Mr. Burman and Mr. Toder on their blog at the Tax Policy Center’s website (http://taxvox.taxpolicycenter.org/blog/_archives/2008/10/20/3938265.html ). The vast majority of those at the lower end of the AGI scale are surely self-employed or moonlighters, but it’s one very good set of data.
    But, if we assume that all of the 900k filers that reflect $200k+ in AGI are all small businesses, how many workers might they employ?
    The Small Business Administration has an extraction of Employment Firms from census data that stratifies employment by size of Firm (http://www.sba.gov/advo/research/us_05ss.pdf ). An Employment Firm is a firm that had payroll expense during the census year. Granted, this data includes corporate entities, as well as, sole proprietorships, but it is another good set of data.
    According to the 2005 census, approximately six million firms employed 166.3mm hard-working Americans. The data is stratified by levels of employment ranging from 823k firms with zero employees each (these were startups or closures that couldn’t count a full employee for a full year) to 912 firms with 10,000+ employees, each.
    The relevant strata are probably those with fewer than 20 employees. Eighty percent (5.4mm) of the firms employed fewer than 20 employees, representing a total employment of 21.3mm employees, or just over 18% of the working population in 2005. This translates to, roughly, on average, four employees per firm. Let’s say, for arguments sake, that all 900k of the “small businesses” we identified above are distributed throughout this strata of Employee Firms. That would tell us that approximately 3.6mm workers could potentially be affected. Even in a “worst case” scenario in which these businesses reduce their staff by one-third, it would, theoretically, only increase unemployment by one percentage point. Not a dramatic number. On top of today’s 6%+ unemployment figures, that would get us close to Clinton-era figures, but nowhere near the Carter-era. So, maybe the increase in individual tax rates would have less of an immediate impact (on employment) but, perhaps more of a future impact on growth for those small businesses.
    [Note: if one takes issue with which strata these 900k small businesses reside by taking it to the next higher strata that might be salient – firms employing 10-29 employees – the numbers begin to get quite dramatic. This strata employs an average of 16 employees each, which would imply that these 900k small businesses employed almost 12% of all employees!]
    However, there is the nagging issue of the other 113mm workers. Are their employers safe from the specter of a tax increase…perhaps. Obama is silent on the issue of changes to the corporate tax rates, aside from raising taxes on corporations engaging in certain activities (unspecified) in an effort to change their behavior. McCain, on the other hand supports a reduction in corporate tax rates, which would increase after-tax cashflow available to invest in growth, and traditionally, spur growth and, ultimately tax revenues.
    I am frustrated by this campaign process more than any other. We have a very specific (and dramatic) issue that is first and foremost on the minds of the voting populace. I am clearly not a statistician, as most any of you who took the time to read this can conclude. But, by wasting a morning, I’ve applied some readily available data to at least frame what the impact of a change in tax policy might be on our (currently fragile) economy. Both of the campaigns employ people who are surely smarter than I, with a lot more time and data available to put a finer point on this analysis. And my point in this exercise was merely to gauge the potential scope of the impact of a tax increase. Neither of them have shared anything even marginally specific about their plans to stimulate the economy. Why haven’t they?
    Clearly, a fact-based discussion is warranted. A fact worth considering is that, on a macro level, a tax increase has NEVER resulted in increased economic growth. To presume that the next president’s term will prove the exception is naively hopeful. As a college girlfriend once impressed upon me, “hope” is not an effective method of birth control. I’m fairly certain it will not prove to be an effective method of economic stimulus, either.

  3. Anonymous  ::  1:23 am on October 27th, 2008:

    Joe's question was not if he was affected, but whether if the business was making 250K Gross, would the tax increase of 4% of gross change prevent him from hiring employees. Well, will it or won't it? I would think it would spur him to expand harder to keep his personal net the same, since cutting back on costs would only increase his tax burden.

  4. Anonymous  ::  1:13 pm on April 5th, 2010:

    See Sara Lalumia's paper “Responses of the Self-employed to the 2001 Tax Act” on her web page. Sara is at Williams College. She did this research while at the Joint Committee: one of only 3 places that have the data to answer this question (the others being Treasury and SOI). In a nutshell, the answer is that the self-employed did not react much to the 2001 tax cuts – which were large.

  5. Anonymous  ::  10:30 pm on November 1st, 2010:

    Perhaps a struggling business, faced with the burden of additional taxes, would choose to throw in the towel instead. And then both jobs and tax revenue would disappear.
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