Health Legislation: Eating the Small Business Seed Corn

The taxes in the House health care bill have the potential to significantly reduce small business growth and formation.

They do this by taxing modified adjusted gross incomes in excess of $350,000. Modified gross income includes dividends and capital gains. The tax rates are increased by 1 percent for incomes of $350,000 to $500,000, 1.5 percent for incomes from $500,000 to $1,000,000, and 5.4 percent for incomes over $1,000,000.

Many people underestimate the effect that this will have on small business. According to the Tax Foundation:

Roughly one-third of business taxes are paid by owners of flow-through businesses — the sole proprietorships, partnerships, and S corporations that are often small in size and entrepreneurial — when they file their individual tax returns [emphasis added].

And

…when adjusted gross income (AGI) reaches $200,000 or more, 67 percent of taxpayers report small business income. Indeed, high-income taxpayers are over two and one-half times more likely to have small business income than the average taxpayer…

Few small businesses have access to public offerings, big bank loans, or government bailouts. Their expansion is funded by their owners who take the profits they earn and plow them back into the business. If those profits are taxed away, there is less money to fund expansion. As the Tax Foundation points out, a tax on business owners acts like a direct tax on business expansion.

How will these taxes affect business expansion? In 2000, Carroll et al. estimated the effect of cutting a sole proprietor’s marginal tax rate from 50 percent to 33 percent. They estimated that decreasing a sole proprietor’s marginal tax rate by 27 percent increased the size of his business by about 28 percent.

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