Sunday, July 22, 2012


DOES SMALL BUSINESS TAX BREAKS REALLY LEAD TO JOB CREATIONS?
Since the Republicans took over the House and many states in the 2010 mid-term elections, their message has remained giving tax breaks to small business owners to spur economic growth and, subsequently, create more jobs. They have based their insistence on renewing the Bush-era tax cuts for everyone, including the proverbial 1 percent, on this claim. Many lay Americans, including from the Democratic Party, seem to be buying into this theory, even when there is no concrete evidence to prove such as a fact. On the other hand, many have made the case that small businesses, for whom the tax break is directed at, do not create enough jobs to affect the unemployment rate; rather, the Fortune 500 companies are the ones that need such breaks, because for every 100,000 jobs created in a month, these conglomerates are responsible for 80%, or 80,000.

I have remained skeptical of the Republican Party’s claim on this tax break issue, and have taken pains to review and analyze the many –if any – ways such tax largess can spur job growth. Of course, no two economists can agree on a theory, and even where they do, each arrives at the same destination or conclusion through different directions. To help me, and, hopefully, many others like me understand this theory, I am going to try to look at it through a fictitious company called ABC Delivery Services; a family-owned hotshot delivery company considered a middleclass business entity.
Below is a snapshot of annual business/financial report of ABC Delivery Services:

ABC Delivery Services
Ten vans @ $35,000 annual gross income per van =
$350,000
Wages and salary @ $25,000/year per driver =
$250,000
Service/repairs @ $2000/van per year =
$20,000
Insurance coverage @ $1000/year per van =
$10,000
Miscellaneous expenses @ $500/van per year =
$5,000
Total expenses
$285,000
($285,000)
*Profit before taxes
$65,000
*Federal business tax @ 35%
($22,750)
Profit after tax
$42,250
**Profit before tax
$65,000
**Federal business tax @ 25%
(16,250)
**Profit after tax
$48,750
Extra revenue from tax break
$6,500
*Without tax breaks
**With tax breaks of 10%

For better understanding of this analysis, all other financial reporting requirements that might complicate the pros and cons of a tax break have been, purposely, ignored. Also, we will assume that the net profit is also the owner’s annual salary; he has a family of five; two twin teen college sophomores, a wife who works in the business, a high school teenage daughter,  a mortgage and a car note. While acknowledging that this is not typical of every small business family, one would agree that many of such businesses exist in situations similar to this one. We will also assume, for the purpose of this analysis, that the federal business tax rate is 35% and the allowed tax break is 10%, reducing the business tax rate to a flat 25%. Now, how does our fictitious small business owner contribute to job creation?

Let us see. At the 35% tax rate, his after-tax profit is #42,250, which is considered the fruit of his labor, and his to dispose with as he pleases. Now, given that it will cost him about $20,750 to buy and equip one more Ford Econoline; $22,000 for a start-up driver, and $3500 for service/repairs/miscellaneous/insurance, he cannot expand his business, or employ anyone. Obviously, he has not been able to add another van or driver, since he bought a home, and the children started coming. He had spent the last twelve years paying off the business loan he used to start off the business, and he has sixteen more years to go on his mortgage, which cost $1080 a month overall.
Looking at the second scenario with a 10% tax break, we see an increased net profit of $6,500, increasing his total annual profit from $42,250 to $48,750. What, if anything, could this family business do with the $6,500 tax windfall? A few things that has nothing to do with job creation; that family vacation trip they have been putting off for some years; the back porch they have been dreaming of; a Jacuzzi the wife has been wishing for; a down payment, along with a trade-in, on a new truck; put the entire amount in a college trust fund for the daughter; a new roof, re-doing the kitchen, or buying new energy-efficient appliances for the house; so many things needing financial attention. They might decide to save the money towards an expansion, which will take about six years of savings, all things being equal. So, at this rate, it will take ABC Delivery Services about six years of saving the windfall of their tax break to create one fulltime job. I am sure another economist out there will come up with a creative way this company can hire one extra person with a $6,500 tax break; after all, someone invented credit default swaps.

What happens in those six years? Stagnation! Suppose business picks up to a point that each van starts bringing in an annual gross income of $50,000, instead of the previous $35,000? This will put ABC Deliveries in the $500,000 small business bracket; with all previous expenses remaining the same, the company’s financial outlook will be different? But, will it be able to create jobs? Let’s see:
I have re-created the scenario for ABC below at a different income/profit level, while maintaining the same tax rates, 35% and 25%, respectively, and keeping expenses, or variable costs, at the same level. Even at this revenue level, there is not enough increase in tax windfall to support hiring of additional driver, if one was to buy a new or used van. The only improvement is a reduction in the number of years, all things being equal; it will take to save the entire windfall to expand the business –two years.

  

ABC Delivery Services
Ten vans @ $50,000 annual gross per van =
$5000,000
Wages and salary @ $25,000/year per driver =
$250,000
Service/repairs @ $2000/van per year =
$20,000
Insurance coverage @ $1000/year per van =
$10,000
Miscellaneous expenses @ $500/van per year =
$5,000
Total expenses
$285,000
($285,000)
*Profit before taxes
$215,000
*Federal business tax @ 35%
($75,250)
Profit after tax
$139,750
**Profit before tax
$215,000
**Federal business tax @ 25%
($53,750)
**Profit after tax
$161,250
Extra revenue from tax break
$21,500

So, for ABC Delivery Services to add and pay for a new employee and purchase another van, it will have to wait every two years. From the above, it is obvious that for a tax break for small businesses to create jobs, one has to be operating at a certain revenue bracket, and certain wage rate for a 10% break to be effective enough. If ABC were paying its drivers minimum wage, sans health insurance and 40(1) k, it would still not be able to expand at the $350,000 gross revenue rate, but could do so annually at the $500,000 rate. We would not, at this point, consider the effect of a possible expansion on the annual revenues of the existing vans, because it has not happened yet.
To the bigger question of whether tax breaks to everyone making less than $250,000 helps spur economic growth, the jury is still out on that. But one thing we will have to review is how much did the Bush stimulus package of $600 to $1200 some years ago, depending on your filing status, improve the overall economy? Before you answer that question, consider the fact that most of the immigrant beneficiaries of that stimulus package remitted at least half of it to relatives outside the US, and half of the other half used it to catch up on mortgage and credit card bills.

In conclusion, my advice is that governments, legislators and the general public not pay much attention to this Republican theory without performing a thorough analytical review.
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