Why the tax “cliff” threatens the economy

Raymond Keating

Raymond Keating

There’s a great deal of talk about a “fiscal cliff” in political, policy and media circles these days. It references a combination of tax increases and federal spending “cuts” scheduled to kick in at the start of 2013, resulting in a big hit to the economy.

But let’s be clear about the real threat here. Specifically, it’s a “tax cliff” the economy is at risk of falling over in January. Others have called it “Taxmageddon.” Contrary to the assumption of Keynesian economists and liberal politicians, high levels of federal spending are negatives for the economy. Resources, whether through taxes or borrowing, are drained away from the private sector. Reducing federal spending is an economic positive, not a negative, especially when combined with real tax relief.

Make no mistake, this 2013 looming “tax cliff” poses a significant threat to entrepreneurs and small businesses. Consider key tax increases scheduled for the end of this year:

-Personal income tax rates would increase for all income levels, with the bottom rate rising from 10 percent to 15 percent, and the top rate from 35 percent to 39.6 percent. Once the Medicare payroll tax is added in — with it scheduled to increase on upper income earners under ObamaCare from 2.9 percent to 3.8 percent — the top federal income tax would rise from 37.9 percent to 43.4 percent.

This not only creates real disincentives for individuals to undertake entrepreneurial activity, but also directly hits the bottom line of most businesses, since more than 92 percent of businesses pay personal income tax — as sole proprietorships, partnerships, S-Corps and LLCs, for example — rather than corporate income tax.

-The top individual tax rate on capital gains would jump from 15 percent to 20 percent. However, the 3.8 percent Medicare income tax on upper incomes would be extended to cover capital gains as well, driving the top capital gains tax rate to 23.8 percent. For good measure, factor inflation into the equations, and the real capital gains tax rate goes even higher.

From an entrepreneur’s perspective, the capital gains tax arguably is the most destructive tax around. After all, it is a direct tax in risk taking. That is, it diminishes the potential returns on starting up, running and investing in a business. Higher capital gains taxes mean less entrepreneurial activity.

- The tax rate on dividends would increase as well, with the top rate moving from 15 percent to 39.6 percent, plus the 3.8 percent ObamaCare tax taking the top rate up to 43.4 percent. Again, the big issues here are that incentives to invest would be reduced and investors would have fewer resources for investing in small and mid-size enterprises.

-The death tax, which was terminated in 2010, returned in 2011. At the end of this year, the tax would go from an exemption level of $5.12 million (indexed for inflation) and a rate of 35 percent to an exemption level of $1 million (not indexed for inflation) and a rate of 55 percent.

The expanded death tax would hit small businesses, family farms and investors hard. After a lifetime of paying all kinds of taxes and fees, the government shows up at death seeking more than half of one’s assets. That’s devastating to a family business, an investor and the investment that businesses and the economy need to grow and create jobs.

- The president has called for extending 100 percent expensing of capital expenditures for all businesses through 2012 (it was reduced to 50 percent at the end of 2011). But if achieved, that means it would expire next year, thereby creating incentives to shift the timing of investments, but not provide a real incentive for boosting investment overall.

Specific to small firms is the Section 179 expensing provision. In 2011, firms could expense capital spending up to $500,000, with the Section 179 deduction being reduced dollar for dollar above $2 million in capital outlays. In 2012, the expensing level fell to $139,000, with a phaseout cap at $560,000. And for 2013, Section 179 expensing would fall to $25,000 with a phaseout cap at $200,000. Again, the negative for small business investment should be clear to all.

Indeed, this tax cliff looms as a major threat to taxpayers in general, including, most assuredly, the entrepreneurs, small businesses and investors that drive economic growth, innovation and job creation forward.

Unfortunately, by pushing for tax increases to go through on upper income earners, the president is more than willing, apparently, to push many small businesses off the tax cliff.

Interestingly, many of the president’s Democratic colleagues aren’t so sure about this. As noted in a recent article from The Hill, three senators — Claire McCaskill (Mo.), Bill Nelson (Fla.) and Mark Pryor (Ark.) — were less than thrilled with the White House threat it would not stop tax increases on upper incomes under any circumstances. In addition, Sen. Kent Conrad

(D-N.D.) was quoted by Politico saying the current tax rates would have to be extended for all income levels. And in early June, former President Bill Clinton told CNBC he thought all of the current tax rates would have to be extended into next year.

None of these Democrats have been shy about raising taxes in the past, yet have serious doubts about doing so in this bad economy.

In the end, entrepreneurs, small businesses, investors, consumers and job seekers not only need to see that the “tax cliff” has been avoided altogether, but also that permanent tax relief is being implemented to incentivize the entrepreneurship and investment that are sources of economic growth.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. Reach him through the Web site at www.sbecouncil.org.
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Posted by on Jul 25 2012. Filed under Opinion. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.

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