Greg DeVore Stuff I Think I Know

My Tax Plan: The Employee Payroll Savings Account

There has been a lot of talk about tax plans lately over which plan would be best to move the economy forward and generate job growth. Here are what the two candidates are proposing:

Obama

1. Increase taxes on businesses and individuals making more than $250,000 a year. Decrease taxes on those currently paying taxes and making less than $250,000 a year.
2. Give government checks to people who are working but that are not currently paying taxes. (This is between $500-$1000 and is called the Making Work Pay tax stimulus on the Obama website.)

McCain

1. Leave tax rates basically where they are for individuals.
2. Decrease the corporate tax rate.

The Issues With Each Plan

First off, let us assume that tax policy needs to strike a balance between raising revenue for the government and allowing the economy to grow and thrive. You have to find the proper balance or you will run into trouble. If taxes are too high then the economy stagnates. If they are too low then the government doesn't have enough revenue to fund its operation (how much revenue the government should need and how they should use it is not within the scope of this post).

With that assumption, lets look at each plan. McCain would like to lower taxes on corporations. The real question is, would this lead to an increase in job growth? If the government lets businesses keep more of their money will they use it to:

• Create more jobs
• Invest in the business, or
• Enrich their executives

If the money is solely used to increase income for their principle owners and executives then many will say, "Hey, they are getting a tax break just so that they can keep more and more money. That isn't fair. They should pay more in taxes since they have more excess income." John McCain is going to claim that they will use that money to pay for new jobs and grow the economy, but there is no guarantee that will happen.

Obama's policy assumes that all business profits will be used to enrich the owners and executives, and since they have more than they actually need, they should shoulder a higher tax burden, thus "paying their fair share". But by taking their profits at a higher rate you are also preventing small businesses from using that excess money to hire new employees or reinvest in their business.

Small businesses account for 60-80% of new job growth (this is taken from the SBA) so how tax policy affects small businesses is very important (FYI - a small business in this case is any business with less than 500 employees). What if we could set up a tax policy that actually encouraged small businesses to use their profits to hire new employees? I believe there is a way to do this that would be a compromise between the two candidate's plans and would produce dramatic job growth. I am going to call it the "Employee Payroll Savings Account". Essentially it would let businesses pay for employees much like they would a computer. Let me explain.

Tax Time

To understand how this would work you need to understand how small businesses make decisions around tax time. I am only speaking for small businesses. I have no experience with large entities.

At the end of the year, every slightly sophisticated small business looks at their Profit and Loss statement. The business will be taxed on whatever profit remains after Dec. 31. This is why you see many business owners making purchases during the month of December. It isn't because they are buying Christmas gifts for themselves. They are trying to decrease their taxable income. If they can buy something and count it as an expense they will decrease the profit from their business that will be taxed.

The math is actually pretty simple. Say for example, I have $10,000 in profit that is going to be taxed at a 30% rate (these are just random numbers).

If I buy a $4,000 computer in December, and I can count that computer as an expense:

• I pay $4,000 to the computer store.
• The remaining $6,000 is taxed at a rate of 30% so I pay $1,800 to the government.
• I am left with $4,200 in the bank after all is said and done.

If I do nothing:

• I pay $3,000 to the government (30% of my $10,000).
• I am left with $7,000 in the bank but I have no computer.

If I but a $4,000 computer in January (worse case scenario):

• I pay $3,000 to the government (30% of my $10,000).
• I pay $4,000 for the computer.
• I am left with $3,000 after all is said and done.

So to sum it up, here is how it looks:

Scenario	Tax paid	What I have at the end
Buy computer in Dec.	$1,800	$4,200 and a computer
Do nothing	$3,000	$7000
Buy computer in Jan	$3,000	$3,000 and a computer

If I buy the computer in January it actually costs me $1,200 more. I am essentially deciding between a $4,000 computer and $5,200 computer. If I think that I am going to need that computer at all then I am going to buy it in December!

Raise that tax rate to 50%, which is pretty close to what it will be for many small businesses making over $250,000 a year, and the difference is even bigger. At a 50% tax rate the difference in the computer cost from Dec. to Jan. is $4,000 and $6,000.

Why do you care? Why does it matter to you how much money a business has at the end of the year? Because the left over money is what is used to create new jobs. When a company is deciding whether or not they can hire someone they have to make sure they have a sufficient cash reserve to cover that person's salary and benefits.

Let's take a business that had $300,000 in profit. What if they want to hire two new people making $70,000 a year each. Say they feel they want to have a 6-month cash reserve to make sure they can cover the cost of the new employees. That means, when they factor in benefits and payroll taxes they will want to have something like $100,000 on hand.

Well, with $300,000 in profits that should be easy, right? Wrong. At a 50% rate, half of that will disappear. The business is only going to have $150,000 left in January after the taxes are paid. Now the decision becomes a little tougher and the business may put off hiring the new employees until they are sure that they really need them.

The problem is that the business can't deduct the employees' salaries as an expense before their taxes are due. If they were to buy a $100,000 worth of computers then they could decrease their tax liability immediately (Accountants: I know there are certain rules around this but this is just an example so say with me here). If they want to use the money for employees they essentially have to buy the employees in January with their post-tax dollars.

This is why you see businesses buying crazy things at the end of December, and not making crazy hiring decisions.

** The Employee Payroll Savings Account

But what if they could buy employees at the end of the year? What if businesses could set aside a certain amount of money that could only be used for employee salaries over the next year. This money would be shielded from taxes, thus decreasing the taxable income of the business (just like the computer purchase). In the example above, if the company had $300,000 in profit, they could maybe set aside $100,000 into this Employee Payroll Savings Account. They would then only be taxed on $200,000 of profit, saving them $50,000 in taxes.

Over the next year they would have $100,000 to use in salaries for employees (new or existing, but owners or their family members would be excluded). If, at the end of the year they haven't used the $100,000, it would be taxed like normal income. If they try to take the money out before the end of the year for something besides employee salaries they would have to pay the tax on the money at that time.

But essentially, you have decreased by $50,000 the cost of hiring new employees for the business. This would be a huge incentive for small businesses to hire new employees or to increase salaries for existing employees. In essence, at the end of the year, instead of buying a computer that they may not even need, they can set aside money that will be used to grow their business through new hires over the coming year. There is already a precedent for this. They are called Health Savings Accounts and they work essentially the same way.

Seems like something we might want to consider if job growth is really what we are worried about.