Mr. Chairman and members of the committee, thank you forinviting me to testify today on taxes and small business jobcreation.
Numerous provisions affect the tax climate for small businesses,including payroll taxes, capital gains taxes, and the treatment ofcapital investment. But I will focus on marginal income tax ratesbecause that's where there seems to be the most disagreement anduncertainly about the future direction of tax policy. The Obamaadministration has proposed increasing the top two individualincome tax rates, but that policy would likely have a negativeimpact on U.S. economic growth.
The administration has offered some narrow and temporary taxbreaks for small business job creation, but that is not a promisingapproach for tax policy. Instead, Congress should focus on creatinga simple, neutral, and pro-growth tax structure for all Americanbusinesses, large and small. After all, there is no strictseparation of large and small businesses in the tax code. Manybusinesses that report their profits on individual returns aremedium and larger businesses.
New jobs are created by fast-growing businesses, whether smallor large. A new job at a multinational computer chip maker iscertainly as valuable as a new job at the corner restaurant, andprobably more durable. Thus, while my remarks focus on tax policiesfor smaller businesses, large C corporations are also crucial toU.S. economic growth. Policymakers should consider reforms toreduce statutory tax rates on both corporate and noncorporatebusinesses.1
Responses to High Marginal Tax Rates
The Obama administration is proposing to raise the top twoindividual income tax rates from 33 and 35 percent to 36 and 39.6percent, respectively, in 2011. That would likely harm investment,job creation, and growth. Higher marginal tax rates reduceincentives for productive activities, such as working and expandingbusinesses, and they increase incentives for unproductiveactivities, such as tax avoidance and evasion.
If income tax rates rise next year, we may not perceive largenegative effects right away, but changes in marginal tax rates doaffect behavior over the long term. Some high-income workers woulddecide to work fewer hours and retire a bit earlier. Some spousesin two-earner families would decide to stay out of the workforce.Some angel investors would have less cash to invest in start-upventures. And some small businesses would decide not to buy newequipment or hire new workers.
How large are the behavioral responses to marginal income taxrate changes? Many empirical studies have found that reportedincome is quite responsive to the top income tax rates. In a 2009paper, for example, economists Emmanuel Saez, Joel Slemrod, andSeth Giertz noted that the share of income "received by the top 1percent of income recipients started to increase precisely after1981 when marginal tax rates started to decline. The timing of thejump in the share of top incomes from 1986 to 1988 correspondsexactly to the sharp drop in the weighted average marginal taxrates from 45 percent to 29 percent after the Tax Reform Act of1986. [This] provides circumstantial but quite compelling evidencethat high incomes are indeed responsive to marginal taxrates."2
A typical finding is that a tax rate increase that reduces theafter-tax share on additional income by 10 percent results inshrinking reported income by about 4 percent.3 For higherearners, empirical studies usually find substantially largerbehavioral responses.4 That's because higher-income taxpayerstypically have more flexibility on their working decisions and theyhave greater shares of financial and business income, which aremore responsive and mobile than labor income.
A side-effect of these behavioral responses is that governmentsraise less money than they expect from tax rate increases,particularly at the top end. If Congress raised the top income taxrate from 35 to 39.6 percent, the government would gain 4.6percentage points on the money in the top bracket. But reportedincome would fall modestly, and that fall would offset asubstantial portion of the revenue gain. In a recent paper,economist Robert Carroll summarized Treasury estimates that modeledchanges in the top two income tax rates.5 The results suggestthat raising the top two rates would cause reported income ofaffected taxpayers to fall three percent, which would be enough tooffset about 40 percent of the expected static revenue gain.
When considering raising tax rates at the top end, Congressneeds to think carefully about who would be hit. Today'shighest-earners are generally not passive inheritors of wealth, butare usually self-made and entrepreneurial.6 Businessownership and current earnings are the main sources of wealth forthe richest individuals, while inheritances account for less thanone-fifth of the assets of the richest people and that share hasbeen declining.7 As economist Glenn Hubbard noted, "when youlook at data, you see that people who are rich almost entirely arerich because of entrepreneurial risk taking,"8
Many with high incomes are angel investors, who help to fuelsmall business expansion. There are at least 300,000 angelinvestors in the United States, who are often wealthy individualsand have been entrepreneurs themselves.9 They provide animportant source of financing for fast-growing small businesses. Iftheir taxes go up, they will have less money and fewer incentivesto invest, while perhaps parking more of their funds in tax-freemunicipal bonds.
In sum, trying to raise revenue by increasing the top income taxrates is a perverse budget strategy. It would hit some of the mosttalented people in the economy. Since high earners generally havethe largest behavioral responses to taxes, the deadweight losses(or costs of inefficiency) of such tax changes would be quitelarge.10 And since deadweight losses rise more thanproportionally as marginal tax rates rise, raising the top rateswould be very counterproductive.11
Top Tax Rates and Small Businesses
The income tax system has a wide-ranging impact on businesses.It affects decisions on building factories, purchasing capitalequipment, and hiring workers. Rather than trying to micromanagethese decisions through the tax code, we should design a systemwith low statutory rates and neutral treatment to allow businessesto allocate resources efficiently.
More than half of all business income in the United States isreported on individual returns, not corporate returns.12This income is reported by proprietorships, partnerships, LLCs, andS corporations. If the top two individual income tax rates areincreased, it would hit a substantial amount of this businessincome.
It is true that only a small share of the total number of taxreturns with business income would be hit by raising the top twotax rates. That's because many tax returns have small amounts ofbusiness income and many self-employed persons have modestincomes.
Breaking down the data, Robert Carroll looked at just thoseindividual tax filers who derived more than 50 percent of theirincome from a business.13 Carroll found that one-quarterof these taxpayers-who number about 600,000-were in the top two taxrate brackets, and thus would be hit by the proposed taxincreases.
A Joint Committee on Taxation analysis looked at the share ofbusiness income on individual returns that is in the top two taxrate brackets.14 The JCT found that about 25 millionindividual tax returns will report about $1 trillion of netpositive business income in 2011. Of that total, $437 billion, or44 percent, will be taxed in the top two income tax brackets andthus will face the proposed tax increase.
Finally, a microsimulation analysis by analysts at the TaxFoundation looked at the share of the proposed tax increase thatwould fall on business income versus other sorts ofincome.15 They found that the tax rate increasewould raise about $90 billion in 2011, measured on a static basis.Of that total, about $36 billion, or 40 percent, would be from taxincreases on business income.
In sum, various estimates show that while only a small share oftax returns will be hit by raising the top income tax rates, thosethat will be hit represent a large share of all business income onindividual returns. Further, business income represents a largeshare of all the income that will be hit by the proposed tax rateincreases.
How will higher tax rates affect entrepreneurship and smallbusiness growth? Economists Glenn Hubbard and William Gentry lookedat how tax rates affect the initial risky decision to become anentrepreneur, and they found "large" effects.16 Highermarginal tax rates discourage entry into self-employment andbusiness ownership. They found, for example, that the 1993 increasein the top tax rate to 39.6 percent "reduced the probability ofentry into self-employment for upper middle income households by asmuch as 20 percent." Hubbard concluded that today's income tax codegives the message, "if you take a risk and you're successful, wetax you at a high rate; if you take a risk and you fail, we don'tshare that loss with you."17
A study by Donald Bruce and Tami Gurley for the Small BusinessAdministration similarly found that marginal tax rates affectlevels of entrepreneurship.18 Using a detailed empiricalmodel, the authors found that "A reduction in the marginal tax rateon entrepreneurial income of one percentage point would increasethe probability of entry into
entrepreneurial activity by 1.42 percentage points for singlefilers and 2.0 percentage points for married filers."19
Once a small business is up and running, empirical tax researchby economists Robert Carroll, Douglas Holtz-Eakin, Mark Rider, andHarvey Rosen found that higher individual income tax ratesnegatively affect hiring, investment, and expansion. One of theirstudies found that changing the "tax price" (one minus the marginaltax rate) faced by small businesses by 10 percent changed thelikelihood of hiring workers by about 12 percent.20Thus, raising the top income tax rate from 35 to 39.6 percent wouldreduce the likelihood of hiring by affected businesses by more than8 percent.
Another one of their studies found that changing the tax pricefaced by small businesses by 10 percent caused business revenues tochange by about 8 percent.21 That is, raising marginalincome tax rates reduces business growth. Finally, one of theirstudies found that a 5 percentage point increase in marginal taxrates would cause a 10-percent reduction in small business capitalexpenditures.22
The authors noted that tax rate changes affect businesses byaltering the return to marginal investments and changing the cashflow available to fuel expansion.23 In other words,higher tax rates reduce both the incentive and the funding foractivities such as investment and hiring.
The bipartisan Tax Reform Act of 1986 reduced individual incometax rates to a simple structure of 15 and 28 percent. But then taxrates were increased during the 1990s, which the rate cuts ofrecent years have only partly reversed. President Obama's proposedtop individual rate of 39.6 percent is 41-percent higher than the28-percent rate achieved in the late 1980s. (The top effective toprate next year will be even higher if Congress reinstates aphase-out of personal exemptions and a limitation on itemizeddeductions).
Some people think that raising the top income tax rate to 40percent is no big deal because the top rate was even higher duringthe mid-20th century. But the world economy has dramaticallychanged since then. In recent decades, nations have floated theirexchange rates and opened their borders to capital flows, with theresult that cross-border investment has exploded. There is alsorising international mobility of highly skilled workers inindustries such as technology and finance. Thus, in addition to thedomestic reasons to reduce marginal tax rates, the competitivepressures of globalization have convinced most nations to cut theirtop income tax rates.
The average top personal income tax rate in the 30 nations ofthe Organization for Economic Cooperation and Development fell from68 percent in 1980 to 42 percent in 2008.24 Federal taxrate cuts in 1981 and 1986 established the United States as a taxreform leader, but many other countries had caught up to us withtheir own rate cuts by 2000.
The chart shows that the top U.S. income tax rate was the sameas the average top rate in the OECD in 2000 at just under 47percent.25 This data includes both federal andstate-level taxes. Tax rate cuts reduced the U.S. rate to 42percent by 2008, but other countries have been cutting as well,such that the OECD average rate also fell to about 42 percent.
If the top federal rate is increased by about 5 percentagepoints next year, the top U.S. rate with state taxes would be morethan 46 percent. The United States would jump into the ranks ofnations with high individual income tax rates, and we've alreadygot the second-highest corporate tax rate in the OECD.26 Our nation-whichhas been a bastion of market capitalism and individualachievement-has a tax code that is becoming more unfriendly tobusinesses and high-earners than the tax codes of many othernations.
Consider just one possible effect of increased individual taxrates-damaging the nation's historical role as a magnet for smartand productive people. High-skill immigrants have flocked to placeslike Silicon Valley because they could start businesses in a morefree-market environment than other locations around the world. One1999 study found that 24 percent of Silicon Valley firms werefounded by Chinese and Indian immigrants.27 Similarly, a 2007 studyfound that one-quarter of U.S. technology companies launched in thepast decade had an immigrant founder.28
Taxes are only one factor that influences where highly skilledentrepreneurs decide to start businesses. But as other nations haveimproved their economic polices, America may lose one of itslong-standing advantages in attracting the elite of the world'sknowledge workers.
The Obama administration has proposed a number of narrow taxbreaks for business hiring and investment, including a capitalgains provision for small-business stock and a $5,000 tax creditfor small business hiring. Those provisions would complicate thetax code and would be far inferior to broad-based tax ratereduction.
Rather than raising income tax rates next year, policymakersshould consider ways to reduce them. The Tax Reform Act of 1986eliminated deductions and credits while cutting statutory rates ina revenue-neutral fashion. Today, we have a number of large taxbreaks-such as the mortgage interest deduction and the state andlocal tax deduction-that are tilted toward high-earners, and whichwe could repeal and use the revenues to cut the top tax rates. Suchreforms would enhance economic growth because there is a largeamount of business activity in those top rate brackets, asnoted.
Even better, Congress should consider a simplified two-rateindividual tax structure of 10 and 25 percent. Such a structure hasbeen proposed by Rep. Paul Ryan (R-WI) and also discussed in therecent National Academy of Sciences study, Choosing theNation's Fiscal Future.29 The NAS plan has individual tax rates of 10and 25 percent combined with a 25-percent corporate tax in arevenue-neutral package. These lower rates would improve marginalincentives for American businesses of all sizes and in allindustries.
Thank you for holding these important hearings. I look forwardto working with the committee on these issues.
2 Emmanuel Saez, Joel Slemrod, and Seth Giertz,"The Elasticity of Taxable Income With Respect to Marginal TaxRates: A Critical Review," May 20, 2009.
3 Jon Gruber and Emmanuel Saez, "The Elasticityof Taxable Income: Evidence and Implications," National Bureau ofEconomic Research Working Paper 7512, January 2000. See also RobertCarroll, "The Economic Cost of High Tax Rates," Tax Foundation,July 2009.
4 Jon Gruber and Emmanuel Saez, "The Elasticityof Taxable Income: Evidence and Implications," National Bureau ofEconomic Research Working Paper 7512, January 2000.
5 Robert Carroll, "The 2001 and 2003 Tax Relief:The Benefit of Lower Tax Rates," Tax Foundation, August 2008.
6 See, for example, the Forbes list ofthe wealthiest Americans. Matthew Miller and Duncan Greenberg, "TheRichest People in America," Forbes, September 30,2009.
7 Merrill Lynch and Capgemini, "World WealthReport," June 2006, p. 19.
8 Interview with R. Glenn Hubbard, ColumbiaBusiness School, June 15, 2005. Available atwww4.gsb.columbia.edu/ideasatwork.
9 Scott Shane, "The Importance of Angel Investingin Financing the Growth of Entrepreneurial Ventures," SmallBusiness Administration, September 2008.
10 For a discussion of tax rates and deadweightlosses, see Martin Feldstein, "The Effect of Taxes on Efficiencyand Growth," Tax Notes, May 8, 2006.
11 As a marginal tax rate rises, the deadweightloss rises by the square of the increased tax wedge between pre-and post-tax income.
12 Peter Merrill, "The Corporate Tax Conundrum,"Tax Notes, October 8, 2007.
13 Robert Carroll, "The Economic Cost of HighTax Rates," Tax Foundation, July 2009. I am referring to incomefrom flow-through businesses, not income from C corporations.
14 Joint Committee on Taxation, Memorandum toMark Prater from Edward Kleinbard, April 8, 2009.
15 Email from Gerald Prante, Tax Foundation,February 18, 2010.
16 William M. Gentry and R. Glenn Hubbard,"Success Taxes, Entrepreneurial Entry, and Innovation, NationalBureau of Economic Research, Working Paper 10551, June 2004, p.2.
17 Interview with R. Glenn Hubbard, ColumbiaBusiness School, June 15, 2005. Available atwww4.gsb.columbia.edu/ideasatwork.
18 Donald Bruce and Tami Gurley, "Taxes andEntrepreneurial Activity: An Empirical Investigation UsingLongitudinal Tax Return Data," Small Business Administration, March2005.
19 Donald Bruce and Tami Gurley, "Taxes andEntrepreneurial Activity: An Empirical Investigation UsingLongitudinal Tax Return Data," Small Business Administration, March2005.
20 Robert Carroll, Douglas Holtz-Eakin, MarkRider, and Harvey Rosen, "Income Taxes and Entrepreneurs' Use ofLabor," NBER Working Paper 6578, May 1998.
21 Robert Carroll, Douglas Holtz-Eakin, MarkRider, and Harvey Rosen, "Personal Income Taxes and the Growth ofSmall Firms," NBER Working Paper 7980, October 2000.
22 Robert Carroll, Douglas Holtz-Eakin, MarkRider, and Harvey Rosen, Entrepreneurs, Income Taxes, andInvestment," NBER Working Paper 6374, January 1998.
23 Cash flow is important because externalfinance may not always be available to entrepreneurs, or may bemore costly than internal funds.
24 Chris Edwards and Daniel Mitchell, GlobalTax Revolution (Washington: Cato Institute, 2008).
26KPMG, "Corporate and Indirect Tax Rate Survey," 2009.
27Anna Lee Saxenian, "Silicon Valley's Skilled Immigrants: GeneratingJobs and Wealth for California," Research Brief, Public PolicyInstitute of California, June 1999.
28Vivek Wadhwa, et al., "America's New Immigrant Entrepreneurs,"Master of Engineering Management Program, Duke University, January4, 2007.