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Tax cuts: Small biz fact check

chart_tax_parameters3.top.gif By Jeanne Sahadi, senior writer

NEW YORK (CNNMoney.com) -- Republicans say raising taxes on the wealthy would cause small businesses to pull back on hiring. Many leading Democrats say that's nonsense. Who's right?

The answer isn't black and white, despite politicians' confident assertions to the contrary. It's more like multiple shades of gray.

Here's a breakdown of the debate.

How many small business owners would President Obama's plan affect?

Obama wants to raise income tax rates on individuals making more than $200,000 and joint filers making $250,000 and up. That would affect 3% of all taxpayers who report business profits (known as "net positive business income") on their individual tax returns, according to estimates by the Joint Committee on Taxation, the tax gurus on Capitol Hill.

All told, we're talking about approximately 750,000 individuals.

How much small business income does that small minority generate?

Next year, an estimated 50% of all business income reported on individual returns will be generated by that small minority of taxpayers who file at the top two rates, the JCT estimates.

That comes out to nearly $500 billion. (The Bush tax cuts: What you need to know.)

So where do Republicans and Democrats diverge?

Republicans contend that hiking taxes on even a small group of business owners -- because they create a large amount of small business income -- will discourage them from hiring. And it might discourage them from investing in other ways in their businesses. The ripple effect: The companies they might have bought equipment or services from will also take a hit.

The end result: fewer jobs are created, the argument goes.

"This will diminish incentives to expand payrolls and establishment size," former Congressional Budget Office director Douglas Holtz-Eakin, told the Senate's tax-writing committee this summer.

Holtz-Eakin, who now runs a center-right policy institute, estimates that it "would lower the probability that a small business entrepreneur would add to payrolls by roughly 18 percent."

Here's an oversimplified example of the argument: A small business owner reporting $100 in profit is currently taxed at 35%, meaning he takes home $65. If his rate is raised to 39.6%, he only takes $60 home. That loss of $5 means that's $5 less to invest in his business.

Meanwhile, many Democrats say the business owners filing at the top 2 rates don't really represent what people normally think of as job-creating small businesses.

Instead, they say, many are law firm partnerships, investment partnerships and the like. The real job creation, they say, happens at the majority of small businesses whose owners don't file at the top 2 rates.

What's more, tax policy expert Len Burman told the same Senate committee, companies hire a new worker when they determine they'll make money off of the hire, regardless of the employee's tax burden.

"If the hire is profitable before tax, it doesn't matter whether the employer gets to keep 60 or 65 percent of that additional profit," Burman said. "The new worker will also be profitable after tax."

And because businesses can expense many of their investments in the first year and deduct the interest on loans they use for expansion, "raising the marginal rate does not affect the incentive to invest," said Tax Policy Center co-director William Gale. (CBO offers mixed take on tax cuts and stimulus.)

Does anyone know how many jobs are created by small businesses at the top brackets?

Nope. And here are three reasons why:

First, there's no uniform definition for what constitutes a small business. Someone may have income from a rental property that generates business income. Is that a job-creating small business?

Second, there's no indication of what kinds of businesses are represented by the owners filing at the top 2 rates. So it's hard to assess whether their job creation patterns might be similar to other small businesses or how many businesses one taxpayer may represent.

Lastly, there's no neat box that business owners check on their returns that says, "I employ 40 workers and hired 3 new employees this year." (Long-term debt: The real problem.)

Enough with policy debates. How might small businesses react to higher rates?

It's impossible to know. But even some economists who are skeptical that raising the top 2 rates would wallop small businesses say there could be a psychological impact.

"People may look at the marginal rate and get sticker shock," Gale said.

Mari Adam agrees.

Adam is a certified financial planner who counts small business owners among her clients, and she herself runs a small business. She's also a Democrat who believes taxes will have to go up. But she's opposed to that happening in the near-term.

"It's the context that they're raising taxes in," Adam said. "You sense you're being assaulted from every direction."

Business income, home values and investments are all down, Adam noted. Meanwhile, a number of federal and local tax measures have been passed or proposed that could be a hit to small business owners for years to come.

There's a new requirement, for instance, that they issue far more 1099s than they used to. By 2013, a high-income business owner will have to pay more Medicare tax on her wages and those of her employees. Plus, her investment income will be subject to the Medicare tax for the first time.

Until small business owners' personal income recovers a bit, Adam believes, they'll be reluctant to hire or expand.

"None of these [tax] measures is enough, in itself, to put you out of business," she said. "All these things are cumulative. ... The psychological impact of a tax increase now should not be underestimated."

"It's like the frog in boiling water. If you keep turning up the temperature, the frog won't jump out, but eventually you do kill it." To top of page

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