Bush tax cut extensions likely to help small businesses; impact on stocks unclear

As a compromise solution, politicians agreed to extend all the George W. Bush-era tax cuts for all income classes for another two years, while also agreeing to extend unemployment insurance by thirteen months. In addition, the new tax structure envisions reducing the payroll tax by 2 percent.

The stock market initially gave the tax pact a moderate ‘thumbs up’ -- the major indices rose by 0.25 percent and 0.50 percent through mid-afternoon trading on Tuesday (although they largely gave up much of those gains by the time the markets closed).

Longer-term, the potential impact of the tax cuts upon the stock market and economy remain rather fuzzy, given the multitude of other issues facing investors, including perpetually high unemployment in the U.S., a seemingly never-ending sovereign debt crisis in Europe and constant friction with China over trade and currency.

However, for the time being, most observers seem to agree that the extension of the tax cuts will add moderately to GDP growth, while concurrently increasing the budget deficit.

In a research note, Bank of America/Merrill Lynch (BOAML) estimates that the comprehensive tax plan would add 0.3 to 0.6 percent to the economy in 2011 from 2.3 percent, while hiking the budget deficit by between $200-billion and $300-billion next year, up from its baseline estimate of $1.26-trillion.

Unless any last-minute changes are announced, the current tax/unemployment insurance picture looks like this:

• All the tax cuts enacted by Bush in 2001 and 2003 will be extended for another two years, thereby leaving in place the 10, 15, 25, 28, 33 and 35 percent marginal tax rates.
• The 15 percent tax rate on capital gains and dividends will be kept for another two years.
• The estate tax, which amounted to zero in 2010, will be reinstated at 35 percent in 2011, (instead of the originally planned 55 percent) at an exemption level of $5-million). The Tax Policy Center estimates this tax reduction may cost the government about $88 billion over 2 years.
• Benefits for long-term unemployed will be extended for another thirteen months until the end of 2011. The Congressional Budget Office recently said that that a year-long extension of jobless benefits would cost $57 billion.
• The payroll tax on individual wage earners will be cut to 4.2 percent in 2011 from 6.2 percent. The payroll tax funds both Social Security and Medicare. BOAML noted that the reduction in the payroll tax would amount to a savings of $800 for people making $40,000 per year. For those earnings more than $106,800 (the cap on payroll taxes), the savings will total a maximum of $2136. This proposal is expected to cost the government $120 billion.

Emilio Escandon, a partner in the Tax and Accounting Department at Morrison, Brown, Argiz & Farra LLP’s Fort Lauderdale, Fla. office said that the extension of the Bush tax cuts – or what he calls a “freezing” of existing tax rates – will have the most profoundly positive impact on small businesses.

“If a small business owned by individuals was earning $1-million annually and their tax rates were increased to, say, 40 percent, from the existing 35 percent, they would have at least $50,000 less to spend on hiring one or two employees,” he said.

“Historically, small businesses have been job-creators in this country. But, by keeping the top tax rates unchanged, that removes a lot of uncertainties for these small companies and they have more to invest, either in hiring, or in equipment, etc.”

Thus, Escandon believes the tax cut extensions will have a beneficial impact on employment.

“However, I’m not certain that the tax cut extension will necessarily have a significant impact on stocks,” he added.

“But it certainly can’t hurt; it may even slightly help, at least in the short-term.”

Escandon concedes that job-creation has been nonexistent over the past three years or so (even with these low tax rates in place).

“But you have to consider that taxes were not the only thing that influenced the decision of companies not to hire people,” he said.

“There are many moving parts to this discussion. We witnessed a collapse in the housing market, a global credit crisis, among other things, that companies, big and small, were in a deleveraging mode. Companies were more focused on increasing productivity while not adding significantly to labor costs.”

Thus, while there are no guarantees that an extension of tax cuts will necessarily inspire more companies to create more jobs, it is reasonable to presume that an increase in taxes would give them even less incentive to hire new employees.