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File it under‘confused'

There is something striking about the whole debate over how and for whom to extend the Bush tax cuts. And that's how the very business owners and politicians who seem certain that tax shifts will radically harm the economy are bizarrely uninformed about how the tax code actually works. In particular, they don't appear to understand what marginal tax rates and tax brackets actually are.

The Republican majority on the House small business committee unveiled a small business open mic site last week to reveal "what small business owners are saying about the president's plan to raise taxes." Some of what they're saying is that they don't know what they're talking about.

Steve Piechota of Netronix Integration in San Jose, Calif., leads the list of complainers. He explains that his business has grown from three employees to 50 over the past five years and that the "growth has kept our income low, as we've invested back into the company in the form of additional jobs and equipment."

But thanks to tax hikes, he fears that the growth has come to an end. "Bottom line," he warns, "raising our taxes means we'll quit growing, lay off people and stay under the $250k level for income."

The good news for Piechota, in case he's listening, is that this isn't how tax brackets work. The way U.S. income tax brackets work is that taxes are levied on marginal income. In other words, the rate applied to income earned over the $250,000 threshold is irrelevant to the first $250,000 worth of taxable income. If you have $250,010 of taxable earnings then only that last $10 is taxed at the higher rate. In all cases, higher pretax earnings lead to higher aftertax income.

Similarly, a curiously large number of the small business owners surveyed by House Republicans don't seem to understand the difference between profits and revenues. The issue here is that some (but not all) small firms are organized as what are called "pass-through entities" for tax purposes. The exception is what's known as a C Corporation, typically a larger firm. A C corporation files a tax return as a freestanding entity and pays corporate income tax on its profits. If aftertax profits are distributed to shareholders as dividends or share buybacks, then the individuals who profit are taxed on their earnings according to the tax schedule for dividends or capital gains. A pass-through entity, by contrast, pays no taxes. Instead its profits are distributed to its owners (typically a small group of people) and they pay income — but not payroll — taxes on the proceeds.

So when Steve Woodall of Reliant Business Products says his "guess is that we would have to start looking for ways to outsource some of our jobs in order to keep the company solvent," he's missing the point. If his company isn't profitable, he'll have no income to pay taxes on at all.

Dave Parry of MPS Techline of Pennsylvania says his company's revenues go to "paying the 23 employees, buying the necessary raw materials, paying all of the overhead bills, and investing in new equipment." Here, again, he's missing the point that there's no federal income tax levied on income that's used to pay business expenses. Money that Parry spends on employee salaries, for example, isn't his income — it's his employees' income — and they'll pay taxes on it. Absolutely nothing about a tax increase would turn a previously profitable investment, new hire or expansion into an unprofitable one.

That's not to say there's no potentially valid concern about the impact of personal income taxes on small businesses. The key issue is that any business owner needs to decide how much of her or her own personal time and effort to put into the business. Do you stay late burning the midnight oil or close up early to make sure to be able to have dinner with your kids?

Even House Speaker John Boehner has been known to admit that only 3 percent of small firm proprietors would be affected by these higher taxes, precisely because what's taxed is profits, not gross revenue. Relatively few people — whether they're highly skilled professionals, managers of large firms, or owners of small businesses — are successful enough to have more than $250,000 in take-home pay. Those who do, however, derive political benefit from the evident confusion of more humble business owners.

© 2012 Slate

File it under‘confused' 07/16/12 [Last modified: Monday, July 16, 2012 6:20pm]

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