One
of the legacies of the Reagan era is the cutting of the highest income
tax rate from more than 70 percent before Ronald Reagan took office
to 28 percent in 1986. Even though President Bill Clinton raised the
highest tax rate from 28 percent to 39.6 percent in 1993, we have
seen one of the greatest eras of business formation in the history
of the United States during the last 20 years.
It may have just been a coincidence that the
personal computer and Internet came along at the same time as tax
rates fell to cause the business formation, but I don't think so.
In Europe, where the highest tax rates were often in excess of 90
percent until the 1990s and are still usually more than 60 percent,
the personal computer and Internet were also emerging. But Europe
did not get nearly as many new businesses as the United States did.
High tax rates reduce the incentive to take the
risk that starting a new venture requires. If you fail, you take the
entire loss; that is, the government doesn't send you a check to help
cover the loss. But if you succeed, the government takes more than
60 percent of the upside in business taxes. Potential entrepreneurs
may ask, why bother?
Congress is currently debating estate taxes.
Estate tax rates are among the highest tax rates currently in the
IRS code, ranging up to 55 percent. The two major arguments against
the estate tax are, first, that the estate tax represents double taxation,
and second, it destroys small businesses.
The argument on double taxation is the following.
An entrepreneur earns a salary and pays 40 percent or more in taxes.
The entrepreneur takes what is left, invests it and pays 40 percent
or more in taxes on any interest or dividends. At death, the government
may take more than half of this invested money on which taxes have
already been paid. The entrepreneur pays taxes when he gets the money
and pays taxes again on the same money when he tries to pass it on
to his children.
The second argument on how the estate tax destroys
small business has been made most persuasively by farmers. An entrepreneur
(farmer) dies, and the biggest family asset is the business (farm).
The government demands 55 percent of the value of the business in
taxes. The only way to raise the money to pay the taxes may be to
sell the business (farm). |
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Taxpayers in the highest tax brackets pay about
96 percent of all income taxes. The top 1 percent, many of whom are
entrepreneurs and small-business owners, pay more than 33 percent
of all income taxes. These entrepreneurs represent the "goose that
lays the golden egg." If the government gets too greedy and raises
the level of taxation to the point that entrepreneurs lose the incentive
to take the risk to start businesses, the rest of us are going to
have to pay more in taxes or expect less from the government. And
maybe we are going to have to put up with higher unemployment.
The problem with trying to see how far the government
can raise taxes before it affects business formation is that by the
time the evidence is seen, it may be too late to reverse the process.
If rates are raised to the level that they destroy incentives, the
economy starts a death spiral. The government raises taxes so high
that business formation slows or stops and existing businesses do
not expand.
As a result, more people are unemployed. The
government needs more money to help the weakened economy, so it raises
taxes again.
The cycle cuts deeper with each repetition. Cutting
taxes to stop the spiral is too painful because people have become
dependent on government aid.
Based on the research, it is clear that taxes
affect business formation. The United States has been the beneficiary
of many entrepreneurs leaving their homelands with high taxes and
adverse business environments to come here. These entrepreneurs have
created wealth and jobs.
Death and taxes are inevitable. But taxes should
not be so high that they actually cause the death of small businesses
— or, perhaps even worse, abort them before they are born.
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