Do Tax Cuts for Small Business Owners Stimulate Employment?

According to economist Robert Frank from Cornell, the answer is a resounding no.  Tax cuts to small business owners do not stimulate employment.  Here’s the argument.  Suppose that a potential hire will produce 10 units of output per hour for a firm and the output will sell for $2. The worker can be hired for $15 per hour.  Should the firm hire the worker?

Yes, hiring this worker will generate a $5 profit per hour for the employer.  Let the tax rate on the owner’s income be 20%.  Then the take home pay for the owner is $4 per hour.

Now increase the tax rate to 50%.  Is it profitable to hire the worker? Yes, the worker still generates $5 in profit for the firm, but now the owner’s take home pay is $2.50.

Now let the tax rate be 80%.  Is it profitable to hire the worker?  Yes, the worker still generates $5 in profit for the firm, but take home pay for the owner is only $1 now (assuming this is still above zero economic profit for the owner).

Notice how the condition determining whether the worker is hired, a comparison of the wage paid to the value of the output the worker produces (W compared to P*MP from your principles courses), does not depend upon the tax rate paid by the owner. This editorial from the New York Times focuses on this issue in its evaluation of the Bush tax cuts:

Do Tax Cuts for the Wealthy Stimulate Employment?, By Robert H. Frank, New York Times:  The centerpiece of the Bush administration's economic policy has been large federal income tax cuts aimed mainly at top earners. These tax cuts account for much of the $2 trillion increase in the national debt projected to occur during the Bush presidency. They prompted a large group of Nobel laureates in economics to issue a statement last year condemning the administration's "reckless and extreme course that endangers the long-term economic health of our nation."  The question of whether to make the tax cuts permanent is still on the Congressional agenda. So it is an opportune moment to examine the president's argument in support of them. ... the president portrayed his tax cuts as the linchpin of his economic stimulus package. He argued that because most new jobs are created by small businesses, tax cuts to the owners of those businesses would stimulate robust employment growth. His policy thus rests implicitly on the premise that if business owners could afford to hire additional workers, they would. But ... [w]hat matters is whether hiring will increase their profits.

The basic hiring criterion, found in every introductory textbook (including those written by the president's own economic advisers), is straightforward: If the output of additional workers can be sold for at least enough to cover their salaries, they should be hired; otherwise not. ... The after-tax personal incomes of business owners are irrelevant for hiring decisions.  … In brief, the president's claim that tax cuts to the owners of small businesses will stimulate them to hire more workers flies in the face of bedrock principles outlined in every introductory economics textbook.

But what about the increase in income?  Won’t the owner spend more with $4 in profit than with, say, $2.50 in profit per hour thereby stimulating employment?

A second way the Bush tax cuts might have stimulated employment is by inducing the wealthy to spend more on consumption. But a large share of the tax windfalls received by the wealthy are not spent in the short run. … Had the dollars required to finance the president's tax cuts been used in other ways, they would have made a real difference. Larger tax cuts for middle- and low-income families, for example, would have stimulated immediate new spending because the savings rates for most of these families are low. … Grants to cash-starved state and local governments would have prevented layoffs of thousands of teachers and police officers. And many useful jobs could have been created directly. For instance, people could have been hired to scrutinize the cargo containers that currently enter the nation's ports uninspected.  Economists from both sides of the political aisle argued from the beginning that tax cuts for the wealthy made no sense as a policy for stimulating new jobs. And experience has proved them right. Total private employment was actually lower in January 2005 than in January 2001, the first time since the Great Depression that employment has fallen during a president's term of office.

When we talk about lackluster employment figures and worry about why employment is lagging behind output during this recovery, perhaps we should quit debating whether interest rates should be 3.25% or 3.50% and get to the crux of the matter.  I'll debate questions about monetary policy as long and passionately as anybody, but there are better policies than tax cuts for the wealthy to stimulate employment, and our time would be better spent bringing those issues to light rather than endlessly debating the potential for and necessity of another .25% rate increase.

Comments

[William Polley]

You leave out one thing that helps to make the case for the tax cuts (some of them at least) benefitting employment. If the tax cuts encourage investment in capital, and if labor and capital are complements in production, then there will be additional employment. To argue this, you have to argue that the added capital raises the value of the worker's marginal product.

But you and Frank are right that lowering the tax on the owner's personal income won't help much.

What this means is that we need to start having meaningful debate on the kind of tax cuts that have the most desired effect. In the shadow of 9/11 as the push to accelerate the tax cuts went into overdrive, this discussion was cut short. I wouldn't be opposed to having it now. Better late than never.

[Mark Thoma]

Thanks, and I agree. Given recent debates I've had about how hairy my shirt is, it might surprise people to hear that I believe that certain types of tax cuts can and do stimulate employment and growth. There is empirical evidence to support that position. But those aren't the types of tax cuts we got ...

[TDM]

It is very easy to win a debate when you write the script for both sides.

Most job creation involves large amounts of risk. Add risk to the calculations and then taxes do matter.

And now savings are bad? If the rich don't spend their money then someone else will. The government is now spending more money earned by the rich then they did before.

[Bruce Webb]

In my view it call comes down to fetishism of the Private Sector and a total rejection of New Deal principles. If your societal goal is to increase national employment then giving tax cuts to the wealthy on the off chance that they will invest them in a way that increases employment is rather the long way around. There is just as much chance that they will invest the money in modernizing a manufacturing plant in ways that eliminate jobs. Or investing overseas. And from a personal and societal perspective (not focused solely on employment per se) they would be perfectly justified in doing so.

Now if your real goal is cutting taxes and maximizing wealth among the already wealthy then fine, but crying crocodile tears about employment as your justification for tax cuts falls on deaf ears after you run it up against economic reality.

If the government wants to expand employment it has a tried and true method: invest directly in infrastructure or for that matter buy more planes and tanks.

"Trickle down" just like "privatization" has always been more ideological than economic. If you hate FDR and his whole legacy then shout it out openly, embrace your inner Norquist. But this continual attempt to sell these policies as if they are really designed and intended to improve the lives of workers is a pure sham. Or at least until people produce some numbers.

[spencer]

Interestingly, since the personal income tax was introduced the correlation coefficient between the marginal tax rate and economic growth has been plus 0.1.
So maybe there is a lag. The correlation between the marginal tax rate and economic growth in the next year is plus 0.2. So maybe you need to smooth the data. The correlation between a five year moving average of the marginal tax rate and a five year moving average of real gdp growth is plus 0.3. The historic facts support the argument that individual tax rates has no, or an extremely modest negative impact on growth.

Yes, small business reportedly accounts for much of employment growth, but the bulk of investment is still done by large corporations. Changes in corporate tax rates and economic growth do at least have the correct sign.

[anne]

Bob Frank is good folks.

[Mark Sullivan]

TDM is right about risk. The profit from the marginal worker is $5 only if all ten units are certain to sell. That 80% tax rate affects the owner's expected value calculation if there's a chance that fewer than eight will sell.

[anne]

Remember, if you turn me in as a source I will deny all :) Watch for Oregon birds.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=3243&u=178|301|...

Brown Thrasher
New York City--Central Park, Azalea Pond.

[anne]

http://www.nytimes.com/2005/07/07/business/07sbiz.html?pagewanted=all

When Entrepreneurs Risk It All and Lose
By LOUISE WITT

Listening to Rick Girard describe his bustling landscaping business outside Orlando, Fla., as one of the state's largest, you might not guess that his first lawn care venture was a bust.

He started it in 1989, when he was 19, and shut it six years later, letting 30 workers go and filing for bankruptcy protection from creditors. Though his company was growing, it could not pay its bills. Like many young entrepreneurs who lack a track record, he had personally guaranteed much of his company's debt. "Overcoming the stigma of bankruptcy was almost the hardest thing I had to do," he said.

Afterward, struggling on a $32,000 salary, Mr. Girard borrowed $1,000 from his father-in-law, bought a truck, and started another landscaping business with some partners. That one also ran into problems, and in 1998, he formed one with his brother Randy.

Learning from his mistakes, he has since built Girard Holdings into a $16 million operation, with 220 employees, garden centers, landscaping services and a pool-and-patio business....

[cl]

"Yes, small business reportedly accounts for much of employment growth, but the bulk of investment is still done by large corporations."

Spencer, I hear this quoted all the time. Can you give me the source of this --small business creates most of the employment -- what numbers are used to drive this calculation? Or is it an urban legend?

[pgl]

Frank's argument holds for a tax on economic profits but not necessarily for a tax on accounting profits - which is Bill Polley's point. Others are hinting at another argument that Glenn Hubbard raised many years ago. If capital markets were perfect, the extra liquidity from this type of tax cut would not matter - but capital markets are often imperfect.

But my real problem with these claims from the pro tax cut for small businesses comes from a general equilibrium framework. If we can encourage more investment in the small business sector (because of something along the line Of Hubbard's argument) and hence more small business employment, this extra investment crowds out investment for large businesses (I'm assuming that savings is less than perfectly elastic) which means we get less large business employment as we get more small business employment.

[spencer]

Suposedly the source of the small business creating
jobs stems from the Small Business Administration.

I have always considered it suspect, but have never tried to prove or disprove it. A few years ago the
issue was called into question, but I did not save any of the discussion.

that is the reason I said "reportedly".

[pgl]

Per the claim of small business being the source of the most job growth - I have to wonder if this is gross job creation or NET (as in news jobs created minus jobs lost). If most of the net job creation came from small business and if this trend continued for long enough - wouldn't most of American production eventually be from small business? Of course, one could argue that labor productivity in small businesses are low, which means they create low paying jobs. Now is that a good thing?

[save_the_rustbelt]

Having been involved in hundreds of small business decisions over the past thirty years, let me weigh in:

Tax cuts matter in the sense that entrepreneurs always have tight cash flow and anything that improves cash flow is helpful.

On the other hand, it is a whole lot more complex than the supply siders let on. Everything from market research to seat-of-the-pants intuition goes into decision making.

I consider myself a supply-sider, but also consider most supply side arguments to be too simplistic. Many other factors are involved.

[vorpal]

I'm with rustbelt.

If taxes are high, then the area must have a high level of services available to the business community.

Sometimes taxes can accomplish things that businesses can't do, for one, they can provide quality schools for the workers families, so they don't have to pay for private education. Or reliable energy and transportation services that businesses depend upon but can't finance themselves.

Ideal is low taxes and high services. This means that the community is efficient in using its tax resources.

In this day and age, I think communities should focus on energy and transportation cost control. If a community could tell a business that it has a reliable and efficient energy, and a reliable and efficient means of getting workers to work and product to the market, then that would be appealing to a business, especially with energy costs getting so crazy.

[Michael]

Re Small business job creation
Edmund Andrews wrote a piece in the Times Sep 2004
http://query.nytimes.com/gst/abstract.html?res=F60B17F83E5D0C728EDDA00894DC404482&incamp=archive:search
citing research from Zoltan Acs of Merrick U and from Cordelia Oklolie at BLS that the % of total employment at small businesses has been quite stable, but that a significant part of employment growth comes from a small subset of companies which move quickly from small to big, think Microsoft or Google. Macro policies probably don't have a lot of impact here, but policies that make it easier or more attractive to START a new business may create jobs in the long run, including lower marginal tax rates or as you note, resonable bankruptcy protection. But tax cuts wouldn't affect the Short-run behavior of these fast-growth companies