The Importance of Small Business to the U.S. Economy: Small business drives job growth in this country. The SBA reported that between 2002 and 2003, companies with fewer than 20 employees created 1.6 million jobs, companies between 20-499 employees added 400 thousand jobs and businesses with greater than 500 employees had a net loss of a million jobs. Many entrepreneurs trade in their secure job at the big company for the risks and rewards of creating a small business.
Starting a new business is risky. An entrepreneur has a vision, either raises some cash to get started (risking his or her home equity, borrowing from relatives, or finding outside angel investors) or invests using “sweat equity” (working for nothing for a long time). Many businesses fail and many entrepreneurs have to start over. Like trying to become a rock star or win the lottery, the dream outweighs the realistic odds of success. Yet this is what defines our country, and the ability of an American to follow a dream and become a new Sam Walton or Bill Gates drives a lot of people to try.
Small Business Basics: A small company sells something to create income. Whatever is sold costs something—this “cost of goods sold” can be large when manufacturing or reselling a product or small for consultants utilizing their expertise in a certain area. Subtract the cost of goods (including freight costs) from sales income and you get Gross Profit. The problem is there are a lot of other expenses. These expenses include the salaries for employees, health care insurance costs, rent, interest payments, utilities, legal bills—the list is long. Subtract these from Gross Profit to determine Net Profit. This is how much money the business earned (on paper) and what is then subjected to “Corporate” taxes.
However, most small businesspeople don’t take that Net Profit home. They reinvest it in the business—they buy assets like office furniture or equipment, they buy inventory, and they extend credit to their customers to help them grow. The customers (hopefully) pay 30 or 60 days after their purchase. But suppliers have to be paid, usually before the customers pay. Most businesses have money “on the street”—the difference between their receivables and payables. A business may take out a loan from the bank to help fund this working capital. Finally, a small business has cash. Cash is what’s left over after all the above.
Cash is king! And there aren’t many small businesses that have much cash sitting in the bank. It’s being used to pay employees, to pay vendors, to invest in assets. Companies have gone out of business because they ran out of cash, even though on paper they were profitable. Small business owners have everything—their home, job, savings, their reason for being, and their cash—tied up in their business.
Small Business Response to Tax Increases: So now the government wants to increase taxes. What happens? How can a small business respond?
Remember, payments to the government are cash out the door when due. There is no room for negotiation. Chances are there isn’t cash in the bank to pay the tax, so it has to be found somewhere else in the business. An owner can reduce expenses, eliminate bonuses, postpone all new hiring, or even reduce the number of employees. A second choice is to lower the working capital. Cut inventory to the bone. Don’t invest in new assets, or delay repairing the current ones. String out payments to suppliers. All of these actions lead to reduced sales and a focus more on survival than growth. Some or all are necessary to free up cash to pay the new taxes.
Higher taxes hurt a lot of people in this situation. With lower sales and lower salaries--the end result of coping with tax hikes—total tax revenues will fall even as the tax rates actually increase. Small businesspeople just want government to stay out of the way and allow them to build their companies. They don’t want grants or enterprise zones—just lower taxes! Lowering tax rates will spur the risk taking, entice new entrepreneurs, expand the job growth and give new businesses a little better chance of succeeding.
Tax Rates and the Global Economy: This is taxation on a micro scale. Like it or not, we live in a global economy. Businesses are like animals—they want to survive. It can’t be done in the short run, but over time, businesses can move to better, less hostile environments.
Let’s look at a local Philadelphia example. A small business is created, should it be located in Philly or the suburbs? Keeping taxes at a minimum will give the business a better chance of survival. Philadelphia has three primary taxes on businesses and their employees: a Gross Receipts tax (a sales tax on business revenues), a Business Privilege tax (a tax on business Net Income), and finally a Wage Tax on employees. Philadelphia charges (in 2003, according to philadelphiaforward.org) 0.21% for Gross Receipts, a 6.5% Net Income tax, and a 4.3% Wage tax. Locate in the suburbs and the Gross Receipts tax is probably about a quarter the Philadelphia rate, there isn’t a Net Income Tax, and the employee wage tax is well under 1% on average, and in many places doesn’t exist. The Gross Receipts tax has to be paid even if the company loses money.
Is it any wonder all those office buildings have been built in Conshohocken, just over the city border? A small business is not Comcast and can’t negotiate concessions from the city, it pays list price. Location (or even relocation) is an easy decision for most small businesses. Unless the customers require a business to be in the city, it will go where costs are lowest. We love Philadelphia, all things equal we’d rather be there, but it isn’t worth that much.
The same logic applies on a global scale. The U.S.corporate tax rate has been just under 40% since the late 1980s. At the time, that was significantly lower than tax rates in the non-U.S. G-7 as well as the second tier countries (OECD). Those countries have been consistently lowering their corporate tax rates, so that they are now, on average, at rates between 30% and 35% (taxfoundation.org). The U.S.has become uncompetitive on a global scale when it comes to government taxation.
Increased taxes cause the same problems for corporations as for small businesses, only on a larger scale. These large (many times multinational) corporations can and will choose to invest in the lower tax countries, all things being equal. Fortunately, the U.S. still has the best market for customers, safety, rule of law, and ease to do business versus many of our competitor countries. Politicians concerned about reducing or eliminating the outsourcing of jobs should look at the tax code. Higher taxes will create that “sucking sound” of jobs going down the drain to other countries.
Benefits of Lower Tax Rates: Who benefits when corporations see lower tax rates? Who owns their stock? Take a look in the mirror. We own the stock, we benefit. In 2005 nearly 57 million households (over half) in the U.S. owned stock, or equities (sia.com). We own them directly, through mutual funds, or in our retirement pension funds and 401k plans.
Raising taxes on any company, large or small, will hurt all of us. It will reduce new job creation, drive businesses away from our cities and our country, dampen real and potential growth, decrease entrepreneurial risk taking, and reduce tax revenues. We shouldn’t be discussing tax hikes, but tax decreases to keep us competitive and growing, in new jobs, in tax revenues, and in the number of entrepreneurs striving for the American dream.
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