The Entrepreneurial View #526                                                               

The Perplexing Obama Tax Increases

by Raymond J. Keating

No matter where one happens to be on the economic spectrum - for example, from Keynesian left-winger to supply-side conservative - there would be general agreement that it's not a good idea to raise taxes during a severe recession. The reasoning would differ, but the advice not to raise taxes would be pretty much the same.

Yet, here we are in a long and deep recession, and President Barack Obama has presented a budget that includes a large number of tax increases.

What's the deal?

Well, the assumption must be that since the tax hikes would not kick in until 2011, then it's okay. The President and his budget advisers must be thinking that the economy will have started to recover by that time, and so tax increases wouldn't hurt.

Of course, that is not the economic reality.

Not only does it look like the economic recovery - whenever it does start - will be an under-performing one, but looming tax increases promise to have negative economic effects before and after they are put into place. After all, individuals and businesses make decisions based on their current and future situations. They make plans, and the threat of future tax increases, for example, affects such planning.

Consider a variety of the Obama tax increases.

• The two highest income tax brackets would be increased from 33% and 35% to 36% and 39.6%, respectively. These higher taxes not only make working, saving and risk taking more costly, but they would hit the bottom line of many small businesses. Last year, the U.S. Treasury Department reported the following:

- "About 70 percent (about 1 million) of the 1.4 million tax returns that benefit from lowering the top two tax brackets from 39.6 percent to 35 percent, and from 36 percent to 33 percent, are flow-through business owners.   Nearly 540,000 of these taxpayers receive more than 30 percent of their income from flow-though businesses."

- "About 81 percent (about $27.3 billion) of the total $33.8 billion in tax relief this year from lowering the top two tax rates will be received by flow-through business owners.  Individuals with more than 30 percent of their income from flow-through businesses receive 44 percent (or about $15.0 billion) of the total tax relief from lowering the top two tax rates."

In addition, these higher income earners would get hit by the imposition of a deductions cap on, for example, charitable contributions, mortgage interest and investment expenses. The purpose is to expose even more dollars to taxation.

• Under the Obama plan, the top capital gains tax and dividend tax rates paid by individuals would be increased by 33 percent, from 15% to 20%. In a period during which it is extremely difficult for businesses to access the capital needed to grow and create jobs, these are particularly bewildering tax hikes. That's especially the case with a higher capital gains tax, which would serve to discourage and diminish investment in a wide array of entrepreneurial ventures.

• For good measure, the top tax rate on carried interest would rise from 15% to 39.6%. It has been common for decades in tax law to treat carried interest earned by general partners as capital gains income. That made sense. Carried interest is not the same as ordinary wage or salary income, which are paid no matter how the business performs. Carried interest is subject to significant risks since it is tied to the success of the venture, and is of the same substantive quality as an equity investment.

• The estate tax - or more accurately, the death tax - is currently scheduled to disappear in 2010, but would the return in 2011 with a top rate of 60% and a $1 million exclusion. The wise course would be to make the termination of this unfair, anti-family-business, anti-family-farm, anti-investment tax permanent. Instead, the Obama budget plan calls for keeping the tax around with a 45% tax rate and an exclusion level of $3.5 million for individuals.

• Oil and chemical businesses would face the re-imposition of an excise tax to fund the Superfund program. Unfortunately, rather than arbitrarily raising taxes on these businesses to pay for Superfund, this wasteful and inefficient program is in desperate need of reform and reevaluation. Superfund would be an ideal place for the President to start carrying out his pledge to spend wisely and deal with programs that do not work. Unfortunately, it is business as usual with this proposal, as more tax dollars are being thrown at Superfund.

• Finally, during an era where the need for reliable, affordable energy has become evident to most everyone, the President has proposed raising tax and regulatory costs on the energy front. For example, the Obama budget would end "last in, first out" accounting, which is used by many industries and businesses. But the main target here is to jack up taxes on domestic energy producers.

And then, there is the President's call for establishing a cap-and-trade regulatory scheme to deal with so-called manmade global warming. Over the period of 2012 to 2019, Obama would auction off rights to emit greenhouse gases. The Obama administration expects to raise $646 billion from this auction. This, of course, is nothing more than an energy tax, and the negative effects will spread throughout the economy, as has been documented by so many economic studies in recent years.

The signals being sent to fossil fuel energy producers by such tax and regulatory proposals is the following: Don't bother making the enormous investments necessary for energy exploration and production because the agenda is focused on raising your costs and placing your returns in doubt. That's bad news for businesses and employees within the energy industry, and it's bad for people and businesses through out the economy as the U.S. would face higher energy costs and lost competitiveness in the global economy.

The President seems to think that some targeted, temporary tax cuts will help the economy, while permanent tax increases will do no damage. The reality is the exact opposite. Those targeted, temporary tax cuts included in the federal stimulus bill will do little to boost entrepreneurship and investment that drive our economy forward, while his tax hikes would serve to restrain such crucial economic risk taking.

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