Don’t get too excited by tax cuts for new jobs

By James McCusker

What’s not to like about a tax cut?

President Barack Obama recently announced his plan to increase employment by providing tax cut incentives to small businesses to begin hiring new workers. In most recessions, including this very painful one, employment tends to trail consumption and investment as the economy begins to recover. To spur businesses to speed up hiring decisions, the administration plan will offer tax credits and incentives to small businesses that hire new workers as well as encouraging commercial loans to small businesses.

Everybody likes tax cuts, and there is nothing wrong with this plan — except that it is long overdue and we are still talking about it, not actually doing it.

That said, we should not raise our expectations too high. As an incentive, for example, a tax credit for small business is not likely to make much difference in hiring decisions. The reimbursement for Social Security taxes, though, is much more likely to have a positive effect.

The reason for the difference in effectiveness is embedded in the way small businesses are organized and the way they operate. Tax credits do not have the same impact on small businesses as they do on larger ones.

For a tax credit to have some impact, the business has to pay taxes. Over the past few decades, though, many small businesses, especially the new ones, have organized as limited liability companies (LLCs), Subchapter “S” corporations, or similar legal structures. Unlike big corporations, these businesses do not pay federal income taxes. Instead all profits and losses flow through the business directly to the owners, who then pay tax on the result.

The net effect is that a tax credit for many, if not most, small businesses wouldn’t have a direct, immediate effect on the net cost of hiring a new worker, and that significantly reduces its value as an incentive.

Another reason to lower our expectations for this program is that in most cases adding a new worker is a business decision that is influenced more by large numbers and longer-term economic factors than by short-term incentives. Despite how businesses are often portrayed, employers do not like layoffs; they don’t want to be forced to terminate anyone’s employment. When deciding to hire a new worker, most employers do so with the idea that the relationship will be a lasting one.

When there is a lot of economic uncertainty, employers are very cautious about making long-term decisions such as hiring new people. There is clearly a mismatch between this long-term perspective and short-term incentives — and this is aggravated by the government’s reputation for moodiness in the tax incentive area. Anyone would be foolish to count on them.

This mismatch is generally believed to be a major reason why our previous experience with this method, the 1977-78 New Jobs Tax Credit program was so disappointing. The program did not seem to encourage much new hiring that wouldn’t have happened without the incentive.

The other element of the jobs incentive program, the payroll tax rebate, is more promising. In this plan, the federal government would reimburse employers for any increase in their payroll taxes this year brought on by additional hours or new workers added. It’s the kind of tax cut that is timely and is as good as cash.

As good as the payroll tax rebate is, though, there is still the question of how much impact it will have. The rebate program would be, in effect, a 7.65 percent discount in the cost of bringing on a new worker, and whether that would be enough to make a significant difference in an employer’s hiring decision is questionable.

The president has also announced a plan to lend $30 billion to smaller banks in communities across the country for the purpose of making new loans to small businesses. This could be a real help if the government does not make it too complicated or tries to get its investment back too quickly.

Borrowed funds can be as much a problem for banks as they are for individuals and it wouldn’t help much if we induce community banks to make risky loans with “hot money.” This is especially true for the smaller, community banks where a large portion of the loan demand is focused on real estate development and construction — economic sectors that are expected to experience slow recoveries.

The best part of Obama’s plan is that it finally draws attention to a neglected area of our economy, small business. And as long as we have realistic expectations for it, as the saying goes — it’s all good.

James McCusker is a Bothell economist, educator and consultant.