The Bush tax cuts debate and the real small business story

It’s hard to avoid the politicians ranting either for or against the extension of the Bush tax cuts. Like many issues in life, for every complex problem there is a simple solution that is absolutely wrong.

Those opposed to the extension often try to separate the issue of “who” gets the extension. The theory is the high income earners should not get the extension and therefore pay more in taxes because they can afford it.

Those in favor of extensions for everyone say if the extension of the cuts isn’t done it will cost jobs and be a drag on the economy.

In this case the unfortunate truth is they may both be right. So if they are both right how do we decide which policy is best.

Let’s take the case of Mary who owns a pest control business. Like many small business owners her income can vary wildly from year-to-year. For the sake of this discussion let’s say that she and her husband, who also works in the business, make $300,000 combined. Since many politicians have said that the tax cuts should not be extended for those who make over $250,000 let’s use that as income above which the Bush tax cuts expire.

So let’s go with that, Mary and Bob currently make $300,000 per year and, if the Bush tax cuts are eliminated, they are going to get a 10% tax increase on income over $250,000. I’ll use round numbers again..their new tax rate goes to 40% from today’s current 36%.

Now Mary and Bob have a good idea. They think they can grow their business next year and increase their income by $50,000 to $350,000 but they will need to hire someone for $32,000 a year to do the job. Seems like a good idea right? Spend $32,000 and make an extra $50,000..easy decision. Well, maybe not. Here’s the math if the Bush tax cuts expire for her:

  1. Mary pays an employee $32,000.
  2. Mary makes additional $50,000 before tax and $30,000 after taxes (40% tax rate)
  3. Mary pays additional tax of 3.6% (difference between old rate and new) on the $50,000 she already makes above the $250,000 tax increase line. That’s another $1,800 in taxes

So what happened here? Mary made $50,000 more and has $3,600 less in cold hard cash. (The math is $50,000 – $32,000- $20,000 – $1,600 = -$3,600)

What would you do? Take the risk of hiring someone for $32,000 so you can lose $3,600?

The same situation if the tax rate for Mary is extended:

  1. Mary hires and pays an employee $32,000
  2. Mary makes additional $50,000 before tax and $32,000 after taxes (36% current tax rate)
In this case if her plan works Mary is break-even. Remember from above, if the tax increase goes into effect Mary will lose $3,600 if her plan works perfectly. Without increasing her taxes she’s break-even.
What’s the difference? If the tax increase goes into effect and Mary decides not to hire the new employee
 the tax effect to Mary is $1,600 and the new employee doesn’t have a job.
If the tax increase doesn’t go into effect what happens? Mary hires the new employee, Mary pays $18,000 MORE in taxes because she made $50,000 more taxed at old rate AND the IRS gets to tax the new employee on his $32,000 salary. Mary makes more money, another person has a job and IRS gets more money. But Mary had to be willing to take the risk! None of this happens unless Mary takes the risk. It’s not the government taking the risk, it’s Mary that has to take the risk. 
There are millions of people like Mary and Bob in the U.S. today making these same decisions every day.
The point of this is that nearly all financial decisions are made at the margin not based on the overall. Mary didn’t make her decision based on the $300,000 she makes, she made the decision based on the next $50,000 she might make. 

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2 Comments

  1. Anonymous
    Posted November 17, 2010 at 6:10 pm | Permalink

    Would Mary be able to deduct the $32,000 from her Taxes? If so, does this help increase Mary’s profitablity of this situation?

  2. Posted November 17, 2010 at 6:49 pm | Permalink

    Thanks for your comment. When I did my example I tried to simplify the concept so the post wouldn’t be as long as the IRS tax code. But you are correct the $32k I used is deductible and the effect depends on if the biz is a C corp or pass thru. I ran a couple of scenarios and the best I can do for Mary under the expired tax cuts is she could net $6k on a $35k employee cost (I used $35k because you need to add the employer share of fica, suts, futa, wc, etc.) I look at Mary’s decision like a poker hand. Would I want to risk a $35,000 loss for the maximum gain of $6,600 if I thought my odds of getting the $6,600 were 50/50? If Mary does nothing and the tax cuts expire it costs her $1,800 additional taxes, which is way less than risking $35,000.

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