Taxing high earners more costs everyone

By Steve Hammes

----

High-income earners have a bull's eye on their back.

When governmental budgets are stressed (when are they not?), some politicians know how to capitalize on the populist attitude that high-income taxpayers are the ones benefiting most from the economy. Therefore, they should be the ones looked to first to close budget gaps. Few elections have been won advocating that the rich pay too much in income taxes.

Voters have often demonstrated that they are willing to support higher taxes on high-income earners as long as it does not catch the middle class (them). Recently, California voters passed a referendum assessing higher income tax rates for those earning more than $250,000. It is easy to support more government as long as someone else has to pay for it.

There is a hidden fallacy to this belief: We all end up paying for it because the cost gets baked into the price of everything we buy.

Start with the fact that 80 percent of businesses have their income taxed at the owner's individual rates because they are pass-through entities; i.e. S Corporations, Limited Liability Corporations (LLC's), partnerships or sole proprietorships. When business income is added to the owner's taxable income, it is easy to get to the highest tax rates. So a higher income tax on these “wealthy” individuals is really a tax on business income.

Like any business cost, higher income taxes have to be passed on to the customer in higher prices (additional revenue). To believe that it will just come out of the margin a business earns is unrealistic. The owners of businesses have to get an after-tax market return on their capital. If they don't, the value of the business will decline. A well-managed business cannot let this happen for long or it is on its way to extinction.

Even businesses that are not taxed as pass-through entities (large corporations that pay taxes on their income) ultimately are affected by higher income taxes assessed to their high-income employees. These are the employees who are most talented and valuable to the business. They also have options in the market place.

These may include demanding that their employers raise their salaries to get them whole on an after-tax basis or moving to another lower tax jurisdiction that may include a different employer.

They may be forced to seriously reconsider that higher compensation job offer they recently turned down now that their income has been reduced by income taxes. Employers will certainly face this when they hire new talent, particularly if it involves moving them from a lower tax jurisdiction.

Business managers who try to relocate talent from about any state to California (highest tax rate in 48 states) will experience this market shock. When employers are forced to increase compensation for the most talented employees, this business cost must be passed onto the customer.

So when we think taxing the rich is just fine because it doesn't cost me anything, think of the successful car dealer, restaurant owner, grocery store or insurance agent in our community that it will affect. The basic rules of finance require that they take this cost, like all others, into consideration when setting their prices.

In the end their products and services will cost more and we will all pay for “their” higher taxes. We just won't notice it, which is the kind of tax that politicians love.

Steve Hammes, managing director of INTEGRUS Consulting LLC in Cedar Rapids, is a CPA, was a part-time adjunct instructor in the Entrepreneurial Center at the University Of Iowa College Of Business from 2008 to 2010, and serves on the board of directors of Bankers Trust Company, Cedar Rapids. Comments: shammes@integrusconsult.com