A Look at the Biden Proposal to Increase Personal Income and Capital Gains Taxes

By at 2 February, 2021, 2:16 pm

Impact on Entrepreneurship, Small Businesses, and the Economy

by Raymond J. Keating-

Raising taxes and using class warfare to justify such increases never make for sound economic policy. And of course, such measures are most troubling when the economy already is struggling. Nonetheless, President Joe Biden has proposed an assortment of tax increases that are targeted at high-income earners, but will wind up inflicting harm across income levels and the economy.

During hard economic times, it’s difficult (though certainly not impossible) to find economists who will argue that tax increases are good ideas. Different schools of economic thought might serve up different reasons not to raise taxes, but the final point on not increasing taxes during a bad economy generates considerable agreement. Indeed, any economists getting out front for tax increases during tough economic times are simply supplanting political preferences for sound economics.

President Biden has proposed increasing income taxes on those earning more than $400,000 annually.

First, Biden would impose the 12.4 percent Social Security payroll tax on earnings above $400,000. Currently, this Social Security payroll tax applies on a wage base up to $142,800. The Biden plan would have it re-imposed at $400,000.

Second, the top individual income tax rate would be increased from 37 percent to 39.6 percent again for earnings above $400,000. In addition, an assortment of deductions would be limited for these earners, thereby further raising the effective tax rate.

Third, various non-C-corp small businesses (such as S Corps, LLCs, and partnerships) currently qualify for the Section 199A “pass-through deduction,” which effectively reduces their top income tax rate from 37 percent to 29.6 percent. Biden would phase this out above $400,000 in income.

Fourth, Biden would raise the individual capital gains tax rate from 20 percent, plus the 3.8 percent Medicare tax, for a total rate of 23.8 percent, to 39.6 percent, plus the 3.8 percent Medicare tax, for a total rate of 43.4 percent. This higher capital gains tax rate would apply to those earning more than $1 million.

(Additional tax increases, such as on C corporations and as related to the death tax, will be addressed in additional follow-up analyses.)

Especially when taken together, these would amount to rather breathtaking and destructive tax increases.

Consider, for example, that the total top tax rate on income for individuals and certain small businesses would jump from 40.8 percent (37 percent individual rate plus the 3.8 percent Medicare tax) to 55.8 percent (the 39.6 percent individual rate, 12.4 percent Social Security payroll tax, and the 3.8 percent Medicare tax).

For other small businesses losing the “pass-through deduction,” the total top income tax rate would climb from 33.4 percent (the 29.6 percent effective top rate plus the 3.8 percent Medicare tax) to the aforementioned 55.8 percent rate.

Factor in state and local income taxes in parts of the country, and the total top tax rate for individuals and small businesses would easily top 60 percent or even 65 percent, under the Biden tax agenda.

And as for the top capital gains tax rate, it would nearly double from 23.8 percent to 43.4 percent. Again, factor in state and local income taxes, and the total capital gains tax rate would approach or exceed 50 percent in parts of the nation.

But some will ask: What difference does this really make? After all, upper-income earners are such a small slice of total earners, and besides they can afford to pay more in taxes, right? You know, paying their so-called “fair share”?

First, there is the fact that upper-income earners carry the bulk of the burden when it comes to paying most of the federal income tax, with, as reported by the National Taxpayers Union Foundation, the top 1 percent of income earners (more than $540,000) in the U.S. paying 40 percent of incomes taxes paid, with those in the top 5 percent of earners (more than approximately $218,000) paying 60 percent of income taxes. Making upper-income earners pay their “fair share” is not an issue.

Second, the data have shown consistently over time that entrepreneurs make up the bulk of upper-income earners in the U.S.  Consider, for example, several findings from a National Bureau of Economic Research study released in 2019 (“Capitalists in the Twenty-First Century” by Matthew Smith, Danny Yagan, Owen M. Zidar, and Eric Zwick):

● “How important is human capital at the top of the U.S. income distribution? Using tax data linking 11 million firms to their owners, this paper finds that entrepreneurs are key for understanding top income inequality. Most top income is non-wage income, a primary source of which is private ‘pass-through’ business profit.”

● “These profits … accrue to working-age owners of closely-held, mid-market firms in skill- intensive industries.” This point is expanded upon later: “A typical firm owned by the top 0.1% is a regional business with $20M in sales and 100 employees, such as an auto dealer, beverage distributor, or a large law firm. Most pass-through business income accrues to undiversified, working-age owners of mid-market firms in skill-intensive industries… Most pass-through business income derives from firms with $5M to $500M in sales operating across diverse geographies and sectors. Despite this diversity, most profits are earned in relatively labor-intensive industries, especially in those that demand skilled labor.”

● “Classifying three-quarters of pass-through profit as human capital income, we find that the typical top earner derives most of his or her income from human capital, not financial capital.” Later, in the study’s conclusion, this point is again noted: “We find that most private business profits reflect the return to owner human capital. Overall, top earners are predominantly human-capital rich, and the majority of top income accrues to the human capital of wage earners and entrepreneurs, not financial capital.”

● “Overall, we find that top earners are predominantly human-capital rich rather than financial-capital rich, and that 53% of top 1% income accrues to the human capital of these wage earners and entrepreneurs.”

● “Most top earners are pass-through business owners. In 2014, over 69% of the top 1% and over 84% of the top 0.1% earn some pass-through business income.”

The point is clear: Increase taxes on upper-income earners means jacking up taxes on hard-working, successful entrepreneurs and small businesses. Such tax increases, in turn, mean reduced resources and incentives for starting up, expanding and investing in U.S. entrepreneurial ventures.

Of course, at the same time, such entrepreneurship is vital to U.S. economic, income and job growth. Let’s be clear: Post-pandemic economic recovery and expansion will not be led by politicians and government programs, but instead by private-sector entrepreneurship and investment.

Indeed, entrepreneurs and small businesses need investors to provide the financial capital needed to start up and expand. At the same time, investing in new and/or expanding businesses is an undertaking fraught with risk and uncertainty. Increased capital gains taxes mean reduced potential returns on investing in American entrepreneurs and small businesses. A surefire way to reduce resources available for and to decrease incentives for investing is to raise taxes on upper-income earners who have the accumulated wealth from which such investment flows. That is the case with higher general income tax rates and especially with increased capital gains tax rates.

Unfortunately, we’ve seen this kind of misguided policymaking before. Coming out of the Great Recession, for example, President Obama and Congress imposed tax increases twice – first as part of ObamaCare in 2010 and again at the start of 2013. Those measures helped to restrain the post-recession recovery. Of course, Biden was the vice president at the time. But we all need to learn from past mistakes, and that includes the negatives generated by class warfare efforts to increase taxes.

If we are serious about getting this economy back on track, then Congress should not only reject increasing personal income and capital gains tax rates, but instead, Members should be putting forth pro-growth legislation that reduces such tax burdens, which will then provide a sound foundation upon which economic recovery and expansion can proceed robustly.

Make no mistake, an agenda of increasing taxes will only serve to restrain and slow the economy as it struggles to emerge from this pandemic.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.


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