That taxes and job creation are garnering the most public attention two weeks before the national election is to be expected. And, correctly I believe, much focus is being paid to the revenue side of the account. However, what shape taxes take, and how they dictate employment and economic prosperity, in the coming years remains an ubiquitous and complex question.
At least one notion resonates with consensus across America: It is the risk-taking entrepreneur who facilitates small-business creation and is the source of our fastest job growth.
OK, now what? One strand of discourse suggests strongly that taxes on high-income earners are intimately tied to the spirit of entrepreneurship. Tax increases of the income, investment or estate variety are thought to impede household savings and firm investment, handcuffing capital owners from pursuing future projects like technological innovation or the purchase of a new factory.
Capital gains and dividends are taxed at a maximum rate of 15 percent, a lower rate than the tax on labor income of most middle-class individuals. For instance, the income for an individual making between $35,000 and $85,000 per year is taxed at 25 percent at the federal level.
However, if a large portion of wealth for high-income taxpayers comes in the form of investments, which it historically has, such individuals may pay a lower effective tax rate as a result. But there are many nuances to the relationship between capital investments, labor and respective taxes.
First, capital gains are the difference between the selling price of a security and the purchase price. There are temporal distinctions as well. Short-term capital gains, corresponding to securities held less than one year, are taxed at the owner’s income tax rate, while longer-term capital gains are taxed at the maximum 15 percent level. Similarly, unqualified dividends are taxed at the regular income tax rate, while qualified dividends receive the 15 percent maximum rate.
It is obvious that the capital gains and dividend policies are of greater concern to those of greater wealth. A disproportionate amount of wealth is comprised of investments as income levels rise. Ignoring for a moment that both income taxes on the highest income earners and capital gains taxes were substantially higher during the 1950s and 1960s, two decades synonymous with economic prosperity, let’s think about the responsiveness of savings/investment and labor supply behavior to changes in their respective tax rates.
Put differently, how much does savings behavior change when capital gains taxes increase? How much do labor supply decisions change when labor income tax increases?
It turns out that savings behavior is relatively unresponsive to changes in capital gains taxes compared to the responsiveness of labor supply behavior to changes in income tax rates. Savers will save, but labor decisions are more sensitive to other factors. Just look at the 1990s and 2000s. Capital gains taxes have decreased, especially from 2003 and 2008 tax reform, while savings rates have also decreased.
OK, so what about the entrepreneurial spirit? I am hard-pressed to believe that those beginning a start-up firm are thinking seriously about taxes on investment gains. In fact, capital gains for low-income individuals are actually taxed at zero percent. What’s more, individuals pursuing start-ups might not be too concerned with an estate tax that only kicks in on estates of more than $5 million.
If the goals toward a more prosperous economy and job creation are to encourage small business growth, let’s think about the factors that underpin the decision to become an entrepreneur. Sure, company owners think long and hard about corporate income taxes and capital gains, and rightfully so. But let’s be realistic. Those issues become more relevant for established firms, not those just trying to make it off the ground.
Dr. Nicholas J. Mangee is an assistant professor of economics at Armstrong Atlantic State University and can be reached at Nicholas.mangee@armstrong.edu.