Imagine you are suddenly given $100. No surprise — if you earn less than $250,000 you are more likely to spend that money than if you earn more than $250,000. Based on that truism, some economists have argued that Congress should not be that concerned about extending the Bush tax cuts for high income earners — including small businesses representing about half of total small business earnings. There are two potential fallacies with this analysis. Hopefully, both the President and the Congress will take them to heart over the next few weeks.First, even if all of the Bush tax cuts are extended neither group is going to suddenly feel any richer. That is because these are “tax cuts” only relative to the tax increases that are written into the law books and scheduled to take effect automatically. While those tax increases will be real reductions in disposable income, extending the “tax cuts” will only preserve the status quo. Simply put, everyone’s take-home pay will be exactly the same (for any given amount of income) as it was for the last decade. For that reason extending the tax cuts — expensive though they may be in budgetary terms — cannot really be expected to stimulate anything, or make anyone particularly happy. For that reason, the potential short-term political benefits of any Congressional action should be disregarded. This is not an opportunity to “win” anything. It is only a potential opportunity to “lose less”.
Second, as to the downside risks, the critical economic issue for small business owners may not be whether they will spend or save. The issue may be whether the amounts they save will go into relatively riskless investments — like low-yielding Treasury bills — or into a relatively risky investment — like hiring more workers. The latter, of course, is what we want. Here too, economists may be right to argue that a 5 per cent increase in marginal tax rates is unlikely to dramatically alter an entrepreneur’s calculus of risk and reward. But they may be missing the point by focusing on the rational side of economic decisions rather than on investor psychology. Consider this example.
Say you have 100 employees costing you $100,000 per year (a payroll of $10 million) and your business generates revenues of $150,000 per employee ($15 million). That’s a net profit before taxes of $5 million. Sweet. After taxes (at current rates) that’s about $3.25 million.
Now demand appears to be picking up, and you could justify hiring 20 more workers. But experience tells you that these new hires will be relatively unproductive for the first year — perhaps generating revenues of only $90,000 per employee — rising to $150,000 per employee in the second year. That means you’d be losing $200,000 in the first year. Only if demand stays up through the second year will you recover that loss, and actually make a net profit over the two-year period of $800,000. At that point, if demand disappears, you can let the workers go without financial loss.
Let’s say you’re inclined to take the risk. You figure you have a 50% chance of losing $200,000 and a 50% chance of making $800,000. By any rational calculation you should make the investment. But here’s where psychology comes in.
What if Congress intervenes by increasing your top tax rate from 35% to 40%? Instead of having $3.25 million of after-tax earnings to spend, save, or invest (as you had each year over the last decade) you have only $3 million. It’s a small reduction, but we know that the psychological impact of investor losses is much greater than the psychological draw of potential profits. In your mind you’ve just “lost” $250,000 to the government. You may well have lost your taste for risking another $200,000 on hiring 20 more workers.
Consumers are not the only taxpayers whose tolerance for risk has been affected by the recession. Business owners too are more likely to husband their resources. That may actually explain the lion’s share of the current unemployment problem. Avoiding further damage to investor psychology — particularly among small business owners — is the strongest argument for preserving the status quo for the next two years. The issue isn’t what’s the most cost effective Keynesian stimulus — the issue is avoiding another shock to the system.
Donald B. Susswein is a Washington lawyer who practices and writes in the areas of taxation, tax and fiscal policy, and financial institutions and products. He served as an advisor on these issues to the U.S. Senate Committee on Finance. He writes a weekly column for Benzinga every Tuesday.