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The Regulatory and Fiscal Cliffhanger for SME CEOs

The typical small to medium company business leader must feel like Indiana Jones, but with his luck about to run out.

The typical small to medium company business leader must feel like Indiana Jones, but with his luck about to run out. A recent Gallup poll reported that 22 percent of small business owners consider “complying with government regulations” as the most important problem they are facing right now, while “consumer confidence” and “lack of consumer demand” were named by 15 percent and 12 percent of respondents, respectively. Recently, The Wall Street Journal ran a front-page story about companies passing up tax breaks owing to the complexity and hassle of taking advantage of the benefits. Many medium- and small-sized companies complain that the cost of obtaining the tax benefit is greater than the benefit itself. “Complexity is costly,” writes John D. McKinnon, the White House correspondent for The Wall Street Journal. “Compliance costs for U.S. businesses and individuals have been rising and now reach at least 1 percent of GDP, or about $150 billion last year, and possibly much more, according to congressional researchers.”

Other estimates, such as a 2010 study by the Small Business Administration, peg the true cost of federal regulations as much higher—$1.75 trillion—or over 10 percent of GDP. Such an amount eclipsed corporate pre-tax profits by $433 billion. A more recent econometric study conducted by the Phoenix Center for Advanced Legal and Economic Policy Studies framed the matter a bit differently. Reducing the total budget of all U.S. federal regulatory agencies by just 5 percent (or $2.8 billion) is estimated to result in an increase in real, private-sector GDP of $75 billion annually, as well as 1.2 million more private sector jobs each year. It is further estimated that firing one regulatory agency staff member will create 98 jobs in the private sector.

Add to this dismal scenario the prospect of facing an increase in tax rates for high-income taxpayers, resulting partly from the sunset of the 2001 and 2003 tax cuts. The president has called for the reinstatement of the higher tax rates—both in his budget and on the campaign trial—as part of getting the “rich” to pay “their fair share.” A Congressional Budget Office (CBO) report that examined the near-term results of these fiscal policies found them to be sufficient to push the economy into recession in early 2013.

It’s easy to see why many SME leaders would be worried. Flow-through businesses—S corporations, partnerships, limited liability companies and sole proprietorships—play a prominent role in our economy. A large fraction of flow-through income is subject to the top two individual income tax rates. These businesses employ 54 percent of the private work force and pay 44 percent of federal income taxes. With the combination of these tax changes in 2013, the top tax rate on ordinary income will rise from 35 percent in 2012 to 40.9 percent; the top tax rate on dividends will rise from 15 percent to 44.7 percent; and the top tax rate on capital gains will rise from 15 percent to 24.7 percent.

Ernst & Young released a study last July (“Long-run macroeconomic impact of increasing tax rates on high-income taxpayers in 2013”) by Robert Carroll and Gerald Prante that examined the likely outcome of such policies, and the long-run economic consequences are not sanguine:

  • Output would fall by 1.3 percent, or $200 billion, in today’s economy.
  • Employment would fall by 0.5 percent, or roughly 710,000 fewer jobs.
  • Capital stock and investment would fall by 1.4 percent and 2.4 percent, respectively.
  • Real after-tax wages would fall by 1.8 percent, reflecting a decline in worker’s living standards relative to what would have otherwise occurred.

The report also examines how what is now called the “fiscal cliff” will affect individual states (see below).

Although the president praises enterprise in public speeches, his suspicion and contempt for business seems to percolate just beneath the surface. Hence, the controversy that erupted over his “you didn’t build it” gaffe in Roanoke, Virginia. He calls attention to his small-business tax credits; but in his stimulus bill, the proposed 2011 jobs act and other legislation, the tax incentives are temporary, while the tax increases are permanent.

The regulatory and fiscal drag on the enterprises that are the backbone of the nation’s economy go beyond the direct costs. The uncertainty about what the government may require from business is inhibiting expansion and decision-making. Our economy will not improve until the president sees the wisdom in changing policies that are clearly not working, or when the electorate decides that someone else should be setting an agenda that works.

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