With the 2017 tax year behind us, this is a good time to assess the effects and implications of the Tax Cuts and Jobs Act, which took full effect at the beginning of the year.
As with all tax reform bills, this one came with many promises, chief of which was to create more jobs. Although it takes a while for the effects of such sweeping reform to become apparent, it’s already clear that more needs to be done to encourage SMB (small and medium sized-businesses) growth.
While corporate profits are at a seven-year high and unemployment remains at historic lows, wages are stagnant, and small business creation is in decline. It’s important to note that each of these trends were set in motion well before the latest tax reform, which begs the question: will the new tax law help or hinder the double whammy of stalled wages and sputtering entrepreneurship?
One aspect of the law promises, in House Speaker Paul Ryan’s words, to create a lower tax for “small businesses, so they can compete fairly, on a level playing field.” The provision he’s speaking of is a 20% deduction on pass-through business income.
Most small businesses are structured as pass-through entities, either in the form of S Corporations, LLCs, or sole proprietorships. Rather than being taxed at corporate rates, business income is passed through to personal income and taxed at individual rates. This new deduction will certainly help many SMBs put money back in their pockets, which could ostensibly lead to more growth in new SMB formation and higher wages for SMB workers.
Unfortunately, the deduction doesn’t go far enough. To qualify for the full 20% break, taxable income cannot exceed $157,500 for single filers and $315,000 for those who are married and filing jointly. This cap is prohibitively low considering more than 60% of SMBs have annual revenues in excess of $250,000.
What’s worse, SMBs operating in “specified service businesses” are barred from taking the deduction. These businesses include healthcare firms, finance and accounting firms, and law firms, to name a few. This is especially disconcerting given that healthcare and financial services are among the top industries for SMB job creation, according to a recent ZipRecruiter study.
The National Federation of Independent Business, a conservative lobbying group, perhaps said it best: “This bill leaves too many small businesses behind.”
So what’s to be done?
Although the pass-through deduction is a step in the right direction for SMB tax policy, it clearly needs to be broadened to include the industries that are currently contributing most to job creation among SMBs. It also needs to be clarified and simplified.
SMBs don’t typically have the luxury of hiring a CPA and tax attorney to navigate the labyrinthine tax code, which has only become more complicated under this reform.
One positive aspect of the corporate tax cut is its simplicity. We are already seeing changes in how large corporations are operating because they can predict the effect the lowered rate will have based on their projected earnings. This is much more difficult to do with the deduction, especially given the lack of clarity surrounding which businesses qualify and how much they will ultimately be able to deduct come April of 2019.
Aside from broadening and simplifying tax incentives for SMBs, two systemic issues must also be addressed if we are to see any further momentum in SMB formation and job creation: the high cost of housing and staggering levels of student loan debt.
Both of these factors have severely limited labor mobility. As people continue to spend a greater share of their earnings on housing and debt repayments, it becomes less feasible to leave stable employment and venture into the risky waters of starting a company or working for a startup.
Policies that provide debt relief and housing assistance for entrepreneurs and workers at small and mid-sized firms would go a long way in stimulating new SMB formation and hiring.