UPDATE: Marc in the comments made a point about sole proprietorships with employees that I’d like to address as well.

Barack Obama wants to reduce taxes for roughly 95% of the United States while raising taxes on the other 5% – those making more than $200,000 per year. John McCain wants to lower taxes on everyone, and attacks Obama’s tax increase on the upper 5% as destroying small businesses and jobs. I decided to do some research on this issues to see if, in fact, raising taxes on those individuals making more than $200,000 would reduce employment or not, and I found out some interesting things. The conclusion, however, is this: Obama’s tax increase on the wealthy will not directly harm small businesses. At. All.

First, some definitions so we all know what I’m talking about. So far as I can tell, the only small businesses that pay taxes at the personal income rate are “sole proprietorships”, the simplest type of business in the U.S. According to NOLO.com, a sole proprietorship may have employees, but the census indicates that the bulk of sole propreitorships do not – they’re considered nonemployers, and they are the largest portion of all U.S. businesses.

In 2005 (the last year for which there is both data on nonemployers and employers at the U.S. Census Bureau), there were 20,392,068 nonemployers with a total income of $951 billion (Source: Nonemployer Statistics, 2005, Total for all sectors, United States). Small business employers1 numbered 5,878,784 (Source: Statistics of U.S. Businesses, All Industries, 2005). The total number of all employer and nonemployer businesses in 2005 was 26,375,614, of which 26,270,852 (or 99.6%) would qualify as small businesses as I’ve defined it above. This would be why people respond when you threaten to increase taxes on small businesses – there’s a LOT of small businesses.

But look closer at those numbers. The average income per nonemployer small business is the total income divided by the number of employers, which in this case is only $46,635. What that means is that the vast majority of nonemployer small businesses (which we can probably fairly say are mostly sole proprietorships) would be unaffected by the Obama tax cut. In fact, since they make so little, they’d get a tax cut, not a tax increase.

Yes, you read that right: the average small business would get a tax cut under Obama’s tax plan, not a tax increase as McCain has suggested.

Various websites have suggested that there are between 15 and 20 million sole proprietorships – that’s less than the number of nonemployers from the Census data, but since some employers are certainly covered while some non-employers certainly aren’t, we’ll assume that all the nonemployers are sole proprietorships. Further, if you look at the Census household income survey for 2005, you’ll find that only 3% of all households made more than $200,000. Since sole proprietorship income is taxed as household income, we can probably fairly assume that only about 3% of all sole proprietorships in 2005 would be affected by Obama’s tax increase.

This means that only 3% of all businesses would see their taxes go up as a result of the Obama tax plan.

And this will cause our employment situation to get dramatically worse how, exactly? It’s not like all 3% will go out of business entirely as a result of the tax increase – the increase just isn’t big enough to drive them all out of business. In fact, according to this BusinessWeek Q&A, the numbers are hard to estimate, but that 9% per year is a commonly used value. If we assume that the Obama tax increase boosts the failure rate for sole proprietorships from 9% to 14%, then that’s approximately an additional 31,000 jobs lost.

Of course, if we say that the tax cut to the other 97% of sole proprietorships drops the failure rate from 9% to 8%, then that’s an additional 198,000 jobs created by the other sole proprietorships, for a net increase of 167,000 jobs. Annually.

Or, as Factcheck.org said when they tackled this issue earlier this year:

McCain has repeatedly claimed that Obama would raise tax rates for 23 million small-business owners. It’s a false and preposterously inflated figure.

UPDATE: Let’s broaden the definition to assume that all small business employers with less than 10 employees are also sole proprietorships. From the employer Census link for 2005 above, there were 4.72 million employers with fewer than 10 with a total of 12.83 million employees. Let’s assume that, as above, no more than 3% of those employers fall into the $200,000+ individual pay bracket. That’s a total 110,000 employers and 31,000 employers for businesses with 0-4 employees and 5-9 employees respectively. Again, if we assume that there’s a 5% increase in business failures equally through both sizes of businesses (from 9% to 14%), that’s a total of 5500 businesses sized 0-4 employees and 2790 businesses sized 5-9 employees that would fail due to the tax increase.

The average number of employees for all businesses in the 0-4 employees category is 1.66 employees per business. The average number of employees for businesses in the 5-9 employees category is 6.66 employees per business. Calculating the job losses we get 8,855 employees in those 5500 newly failed businesses (0-4 employees), plus 5500 for the owners themselves, and 18,582 employees in the other 2790 businesses (5-9 employees) plus another 2790 for the owners. Total is 35,036 extra employees losing their jobs.

Adding that to the 31,000 sole proprietorships from the first analysis, that’s a total of roughly 66,000 jobs lost every year. And just in sole proprietorships alone (never mind the newly expanded 0-9 employees category) we created 167,000 new jobs. Include the 1% decrease in employer small business failures (from 9% to 8%) on businesses sized 0-9 employees and that’s an additional 176,000 new jobs, for a total of 343,000 new jobs across all nonemployer and employer small businesses.

Put bluntly, even if we assume the worst case cost of 66,000 jobs and that every business with fewer than 10 employees is a sole proprietorship (and it’s not), the Obama tax plan is still creating 277,000 new jobs every year.

1 I chose to define “small businesses” as those businesses with fewer than 100 employees. The Small Business Administration uses a much more complicated measurement that depends on the industry and total revenues/number of employees.

UPDATE #2: I’ve been able to do some more accurate calculations with the IRS data from 2005, and the numbers of small businesses (defined as all partnerships, S corps, and sole proprietorships) that fall in to the Obama tax increase zone is actually just over 7%, not 3% as I’d originally estimated. However, the rate of business failure and closure is much closer to 2% of all businesses, and so I’ll need to rework my analysis some. Instead of tagging that rework onto this post, I’ll do a new post sometime next week with the updated analysis.