Raising Taxes on “Top 5%” Would Punish Small Employers and Ordinary American Workers

Despite the slowing economy, Senator Barack Obama admits that he will raise taxes if elected President. But, he assures us, only on the top 5% of income earners in America.

There’s one problem with that – most taxpayers filing as individuals in the top income brackets are actually small businesses, which create most new jobs in America.

At first glance, many ordinary Americans struggling to make ends meet and put food on their tables might set aside their traditional opposition to higher taxes, and welcome tax increases for those who can presumably afford it. This is especially true during an economic slowdown, and as news continues to arrive regarding irresponsible corporate executives driving companies such as Lehman Brothers or Bear Stearns into the ground.

When times are tighter, a “soak the rich” agenda has a certain superficial appeal to many voters. After all, why shouldn’t fat cats pay an even greater share of the nation’s taxes, since they continue to prosper while working families struggle? While working families strain to put food on their tables and gasoline in their automobiles, why shouldn’t those in the top five percent bracket pay an even higher share of taxes?

This is an understandable sentiment.

As understandable as it may be among struggling families, however, here is the problem. Because most of those filing in the upper five percent are actually small businesses, which create most new jobs in America, many of those families will go from struggling to put food on their tables to not being able to put food on their tables at all. And they’ll go from having difficulty filling their gas tanks to not being able to fill their tanks at all.

To explain, one must understand an important – but little-known and little-discussed – fact about individual income tax filers.

Namely, that most small business owners, otherwise known as “S corporations” or “S-corps,” file taxes as individuals. This is not merely some sort of legal trickery or deceitful sleight-of-hand. Rather, this serves a very important purpose.

Small businesses file as individuals for the very good reason that it helps them avoid the double-taxation trap if they instead chose to file as corporations. Under our tax code, businesses organized and filing as conventional corporations, rather than as individuals, are considered separate legal entities from their shareholders. Accordingly, double-taxation occurs because corporations first pay taxes on their annual earnings, just as any individual filer would do. Then, however, the corporations’ shareholders pay taxes a second time on the dividends that they receive. This occurs despite the fact that the very dividend income on which shareholders are paying taxes was already taxed a first time at the corporate level.

Therefore, in order to avoid this penalty of double-taxation, a majority of small businesses file as individuals, or S corporations. In exchange, they give up the advantage that conventional corporations enjoy of being able to pay dividends to their shareholders. And, in order to qualify as an individual S-corp, these businesses cannot have more than 100 shareholders. So there are advantages and disadvantages to filing under either status.

But here’s where it matters to working Americans, and why they should resist the allure of “taxing the rich.”

According to Internal Revenue Service (IRS) data, fully 75% of individual tax filers in the top bracket are actually small businesses. More importantly for purposes of working Americans, small businesses create 75% of new jobs in America.

Voters should therefore ask themselves whether small businesses encountering softening economic conditions would be more willing, or less willing, to hire new workers after their taxes are raised. Are higher taxes more likely, or less likely, to make them invest in productive activities, innovation and putting people to work?

Recent experience seems to answer these questions very clearly.

Prior to the 2003 tax cuts, the American economy lost 540,000 jobs in 2002, and 287,000 jobs in the first quarter of 2003. After the tax cuts, GDP growth went from 1.2% to 3.5%, and we added 311,000 new jobs in the fourth quarter of 2003 alone. By 2006, America was adding over 2.3 million new jobs. Considering the impact of the 2001 Clinton stock-bubble recession, the 9/11 attacks and Enron-type scandals, this recovery was nothing short of astounding.

History teaches again and again that lower taxes boost job growth and the economy, whereas tax increases weaken the economy and deter growth. Because tax increases on the “top 5%” will actually punish small businesses, all Americans must be very careful to consider the possible impact on their daily lives.