Obama’s tax hike on Small Business, and Fact Checking the “3%” Claim

In a previous post, we took on the media’s “Fact Check” effort in the first 2012 Presidential Debate.

 

One consistently tricky argument was the issue of Obama’s tax hike on the top 3% of small business. Romney accepted this figure, but countered that these few provide half of the jobs in the small business world, and a quarter of the total US jobs. Therefore raising taxes on them would hurt the economy and job creation right when it is needed most.

In that previous article I stated that Romney was generally correct, as the pattern gathered from various sources of evidence showed that it is the top brackets of small business that disproportionately provide the bulk of the jobs in the category. However, thought it was clear that the tax rate would hit businesses that create a large number of US jobs, verifying the exact 3% to 50% statement proved to be difficult. No data seemed to be easily available which could provide that level of precision, though no data discredited the claim either. It could be said to be correct in spirit, as well as most likely in the ball park range as far as precision.

Some astute readers including one by the name of “Slick” made some good points and demanded greater precision from The Lighthouse on this issue. I concur.

 Untangling the Question

The reason the claim cannot easily be confirmed, denied or corrected is because it is inherently (though not intentionally) overly complex and mixing two completely different issues.. apples and oranges.

What makes the issue arbitrarily difficult is the “small business” definition. The Federal Government defines them as any business that employs less than 500 people, regardless of size by any other measure (such as revenue or income) and regardless of its legal organization (Corporation, partnership, etc).

In order to tackle the question correctly, the entire “small business” premise must be dropped, though it is the term both candidates repeatedly used. Obama specifically, falsely mocked Romney by saying that he (Romney) would consider Donald Trump a “small business”. We debunked that one fully in the previous article, but it continued to put undue emphasis on “small” business, when it had little if anything to do with the issue at hand.

There is no accepted standard on what constitutes a “small” business, but for the US Federal Government, it is simply any business that employs fewer than 500 people. Trying to disentangle this category of businesses from top earners in general is what causes the arbitrarily placed difficulty on verifying the claim.

Nothing in the Obama plan raises any taxes specifically on “small business” nor is the 3% claim by the JCT that is the foundation for the argument have anything to do with “small business”. The Obama plan raises several different taxes and closes several deductions on INDIVIDUALS who receive business income, a Pass-Trough or Flow-Through Income as it is known. Businesses often organize themselves as a pass-through entity to avoid the double taxation that Corporations function under, as well as for other considerations. Independent individual contractors (such as free-lance), Sole Proprietorship, Partnerships, LLCs, LLPs, and S-Corporations can all be pass-through entities while C-Corporations are not.

Obama spoke of lowering Corporate tax rates to help business, and raising individual Income Tax rates on the wealthy (which he considers those making over $250,000 per year as a household or $200,000 as individuals). Romney and the GOP point out that this strategy is misleading since it would be in fact raising taxes on many businesses who do not pay Corporate Tax rates, but rather are pass through entities. These are in the overwhelming majority small businesses.

The Obama camp back with the fact that his plan would raise taxes on only 3% of small businesses, and then Romney countered that it is those that create half the jobs in the small business world. Arriving at this point, the “switcheroo” has been made; When Obama says that he will only raise taxes on the top 3% of small businesses, he is in fact misquoting the very study he points to. This is where we must begin untangling.

Though it is undoubtedly true that most pass through entities are small businesses (and we will return to this fact), it is a relevant limiting factor for the claim. The study misquoted by Obama by the JCT says the following:

The staff of the Joint Committee on Taxation estimates that in 2011 just under 750,000 taxpayers with net positive business income (three percent of all taxpayers with net positive business income) will have marginal rates of 36 or 39.6 percent under the President’s proposal, and that 50 percent of the approximately $1 trillion of aggregate net positive business income will be reported on returns that have a marginal rate of 36 or 39.6 percent.12 These figures for net positive business income do not imply that all of the income is from entities that might be considered “small.”

Ironically, the quote itself warns about considering all the entities herein small, though it is precisely what Obama did. Two things are important to note, that it is the top 3% of taxpayers with net positive business income that will be taxed at a higher rate, and that this amount will include half of all the business income reported. An interesting detail is that in order to arrive at the 3% figure, only those with net positive income are included, whereas it is known that many businesses (and particularly small businesses) often show a net loss. This can be due to economic conditions, expansions and investment or any other number of factors.

Once we are freed from the “small business” constraint, a number of details are important.

The Data

According to this Ernst & Young study, in 2008 Pass-through entities made up 95% of business entities in the US. They also created 54% of the total business activity in the US, BOTH in terms of jobs and net income. This income was taxed and paid for 44% of all Federal Business Taxes.

It is very important to note the correlation (in this case exact at 54%) between employment and net income. Though it varies in individual situations, companies generate income by employing workers, and likewise income is required in order to pay wages for more workers.

So looking at income, the CRS indicates (in this report) that in 2006 62.15% of all pass-through income (business AGI) is generated by taxpayers earning $250,000 or more. One can assume that if we add the income generated by those making $200,000 or more who are single (who also are affected by Obama’s tax hike), this figure would be somewhat higher. The number of taxpayers with business income reporting over $250,000 is only 6%.

It is this 6% (differing with the earlier JCT number of 3%) of pass-through (and mostly but not all necessarily “small”) that will be hit by the tax increases.

First, it is helpful to take a look at at the general relationship between all business, their revenues and employment numbers. The below chart shows (data from the US Business Census) firms by their total annual receipts and total employees in 2007.

It is important to note that “Receipts” is not the same as net income. However, they are very much related. Receipts are basically the gross sales and gross revenues of the business without deducting expenses. Net Income is thus usually lower than receipts, but it cannot be higher. The data is quite striking. Businesses with receipts of $1 million or more made up 5.24% of all businesses but employed 92.87% of the total workers employed in the private sector!

This information makes Romney’s claim of the top 3% employing half the workers seem very conservative. The above chart includes all businesses, pass-through and regular corporations, small business and large, but the pattern is easily identifiable, companies with higher revenues employ overwhelmingly more workers. Companies with sales of 250,000 and up, employed 97.14% of employees in 2007.

Having seen this very clear indication that the top earning companies (at least in gross earnings) hire the vast majority of Americans employees, let us look for more precise information. Removing the C-Corporations out of the figures would be helpful in case that the hiring patterns of pass through entities and corporations are very different (though we have no indication of that) in relation to receipts. Furthermore, filtering down to actual taxable net income (AGI) is important since that is what the Obama tax increase will target.

Income Business Statistics

Statistics from the IRS are in order. In their integrated statistics page, the IRS is very helpful (an oximoron) on this issue. The most recent year that these detailed specifics are available for is 2003. It is important to note that though that is a while ago, the overall patterns are so extreme, they must have not changed significantly for our purposes.

 

	Wages and Salaries 2003
	(in thousands of $)
	Total by all Firms	Firms earning $250,000+ in receipts	% of Total
C-Corporations	$1,599,662,967	$1,583,920,041	99.02%
S-Corporations	$449,732,962	$433,689,539	96.43%
Sole Proprietorship (non-farmer)	$95,672,919	$68,834,465	71.95%
Partnerships	$244,927,745	$236,561,014	96.58%
Total	$2,389,996,593	$2,323,005,058	97.20%

 

As can be seen, the IRS statistics show the same data confirmed above; in business in general, firms earning $250,000+ in receipts account for about 98% of all wages and salaries expenditures (ie jobs). In S-Corporations and in Partnerships, the ratio is very similar to C-Corporations, namely the high 90’s. It is only in non-farm Sole Proprietorships that the ratio is significantly smaller, at about 72%.  This is logical as many active smaller businesses that employ some people would tend to be sole proprietorships.

It is necessary to get some general understanding between total business receipts (ie sales) and Net Income. The same IRS statistics show some break down by grouping firms in business receipt size, while including total net incomes for each category. The following pattern is seen.

 

				Firms by Total Receipts
	Under 25,000	25,000 under 100,000	100,000 under 250,000	250,000 under 500,000	500,000 under 1,000,000	1,00,0000 under 2,500,000	2,500,000 under 5,000,000	5,000,000 under 10,000,000	10,000,000 under 50,000,000	50,000,000 or more
Net Income	$6,424	$18,514	$39,719	$57,772	$82,064	$125,945	$251,146	$493,742	$1,535,241	$33,654,211
Business Receipts	$6,317	$50,066	$151,295	$343,242	$682,847	$1,515,125	$3,370,576	$6,611,133	$19,349,581	$459,174,859
% Net Income of Receipts	101.69%	36.98%	26.25%	16.83%	12.02%	8.31%	7.45%	7.47%	7.93%	7.33%

In smaller businesses, the ratios of net income out of total receipts tend to be higher and fluctuate more, but luckily, for businesses with total business receipts of $2.5 million and above, the relation is surprisingly stead at about 7.5%. Very similar numbers at these higher brackets exist for all the types of business entities.

This means that for these higher income businesses, for every $100 in sales or business receipts received, the net income reported to the IRS is $7.50. It also means that on average, businesses that earn net incomes of $250,000 earned total business receipts of $3.37 million. The average falls exactly on the 7th category, where the average business earns $251,146. We will use the data from this bracket and those above it to estimate the job creation capacity of the higher income earners in business.

It is true that since this is an average, some of the businesses in the category will earn less than $250,000, but it will be a much smaller portion since the statistics within the category work just like they do in general, where the higher income businesses generate the great majority of the wages. However, it is also true that many businesses in the 3 preceding categories (those with receipts of $250,000 to $2.5 million) will also earn $250,000 or more.  By definition, those that have receipts of less than $250,000 cannot earn that amount in net income, even if their expenses were 0.

In addition, other businesses that are owned by single individuals who earn between $200,000 and $250,000 will also be taxed at higher rates under the Obama plan. This is due to the fact he intends to raise rates on households with incomes over $250,000 and individuals over $200,000. It is therefore a conservative estimate to assume for estimate purposes that the businesses earning over $2.5 million in receipts will be the ones affected by the Obama plan, and not taking into account any businesses that might meet the net income requirements with lesser annual receipts as well as those with $200-$250 thousand net annual incomes owned by single individuals.

So by taking the very modest 7.5% figure for net income (out of total receipts) and counting only firms with more than $2.5 million in annual business receipts, we can get a conservative estimate of the prominence among employers of higher income pass-through businesses. It is especially conservative, since it is among small business and pass through entities that one finds higher rates of return in general than those of larger corporations.

The Bottom Line

 

			(dollars in thousands)
	Total Net Income	Total Wages/Salaries	Top Bracket Net Income	% of Total	Top Bracket Wages	% of Total
C-Corporations	$938,934,425	$1,599,662,967	$907,684,170	96.67%	$1,486,264,966	92.91%
S Corporations	$276,531,538	$449,732,962	$155,996,861	56.41%	$305,100,284	67.84%
Partnerships	$468,552,382	$244,927,745	$335,577,797	71.62%	$201,289,081	82.18%
Sole Proprietorships (nonfarm)	$269,089,168	$95,672,919	$7,315,357	2.72%	$11,324,329	11.84%
Total	$1,953,107,513.08	$2,389,996,593.51	$1,406,574,185.17	72.02%	$2,003,978,658.70	83.85%
Total Pass-through	$1,014,173,088.09	$790,333,626.24	$498,890,015.47	49.19%	$517,713,693.18	65.51%

 

We define “Top Bracket” to the firms explained above, those with at least $2.5 million in total business receipts (and thus usually at least $250,000 in net income). Finally comparing net income and wages directly (through indirect means), we obtain even greater precision by separating the figures by legal organization type.

C-Corporations are the traditional corporations that under Obama’s plan, would not have their tax rates increased. The rest are the pass-through entities that are in question. Quite amazingly, the pass-through Income in the higher bracket we defined is 49.19% of the total pass through income. This is virtually exactly the same figure the JCT quoted as being affected by the Obama tax rates (50% of all pass through income, and about $1 trillion).  This is good supporting evidence of the soundness of  our methods thus far. It also shows how irrelevant the term “small business” was to the issue, as it really is an issue about “pass-through” businesses.

And for the long awaited number, that same high bracket of pass-through firms, which create %50 of the net income of all pass-through entities, pay 65.5% of all wages and salaries in the US! This gives Romney’s claim of 50% a nice margin of safety, and as has already been shown previously, pass through businesses employ over half the total private sector workers in the US (54%) and generate the same percentage of the business receipts. During the debate, Romney quotes this “half of half” as being one quarter of all US jobs (whose employers would be directly affected by the tax increase).

The question remaining is what percent of firms do these account for?

 

	Total Firms	Top Bracket Firms	% of Total
C-Corporations	2059631	228416	11.09%
S Corporations	3341606	231236	6.92%
Partnerships	2375375	82773	3.48%
Sole Proprietorships (nonfarm)	19710079	21088	0.11%
Total	27486691	563512	2.05%
Total Pass-through	25427060	335097	1.32%

Incredibly, this half of income and two thirds of wages is generated by the top 1.32% of pass-through businesses. Whereas in the traditional corporations this higher bracket makes up 11% of the total firms, the numbers are much smaller in pass-through entities.

In pass-through entities especially, the small minority of top income earners pay for a vast majority of the wages and salaries.  At first glance this means Romney’s 3% claim is actually a very large understatement as a tax increase that would affect the top 3% of pass-through businesses would affect an even larger percentage of US jobs. However, whether either of the candidates realized it or not, we can assign this “margin of safety” of over 50% in Romney’s claim.

The difference is in language that the original JCT study used and what the candidates have used. These pass-trough entities are not all owned by a single individual (except the sole proprietorships by definition of course). Some of the S-Corporations and all of the Partnerships (also by definition) are owned by more than one individual. The net income for each individual has to be over $250,000 for the pass through income to be taxed at a higher rate. On the other hand, the pass through income is added to all other sources of taxable active income on all individuals’ returns. So for example, an individual can have $150,000 of income from each of two businesses he is a partner in, and he will qualify for the higher rates on all $300,000. The same holds true for pass-through income that may be added to an individual’s salary for a job in a separate company. Though many of these scenarios cancel each other out, at 1.32% of pass-through businesses paying 65% of the wages, Romney is in safe territory.

Basically we can say that Romney was right on, with an amazing level of precision and if anything was conservative in his estimate. The one issue where he (and Obama) were wrong is by using “small business” as a synonymous to “pass-through” business. In fact, Romney stated that the top 3% of small businesses (that were actually the top 3% of taxpayers with business income) create half the jobs of all small business, and a quarter of all US jobs.

This statement is correct if “small business” is replaced by the appropriate terms. Otherwise, it is extremely difficult to verify, and not relevant to Obama’s tax increase since it does not target small business specifically, but rather pass-through business income. To conclude however, it should be noted that pass-through entities and small business do have a very close relationship.

So though the numbers are not precisely overlapping, the general connotation both candidates gave in this regard is true; pass through entities tend to be small businesses (those with fewer than 500 employees), while C-Corporations are the larger businesses.

To Recap:

54% of US private sector jobs are at pass-through entities. The same is true for 54% of business receipts (in 2008).

The other 46% were employed in C-Corporations.

Pass-through entities paid 44% of federal business taxes.

83% of workers in pass-trough businesses were employed in companies with  500 or less workers (in small business).

52% of the same, were in companies with 20 employees or less.

In comparison, 70% of workers at C-Corporations were employed in companies with 500 or more workers, (not small business).

90% of C-Corporation employees worked in companies with more than 20 employees.

The top 1.32% of pass-through business paid 65% of the wages and generated 50% of the taxable income from pass through businesses in the US.

This 1.32% of pass-through businesses generated a quarter of all business activity in the US and paid 35% of all wages and salaries in the country.

It is this crucial 1.32% of business at least, if not significantly more (though the top 3% of taxpayers with business income over $250,000 ($200,000 for single households) that will be hit by Obama’s tax increases, with a direct effect on huge portions of the US economy and employers.

Hope that helps Slick….