Politics & Policy

The Small-Business Dilemma

Looming tax increases and a stuck-on-zero interest rate are stopping entrepreneurs from hiring and taking risks.

The economy has strengthened some in recent months — helped by inventory building and excess monetary stimulus from the Federal Reserve — while payroll employment is finally stabilizing. But the economic forces that are working in favor of GDP growth in the short term are not creating a longer-term reason for businesses — small firms, in particular — to invest and hire.

The problems facing small businesses remain immense, as evidenced by the job-loss data. The Labor Department’s household survey, which includes small businesses and picks up inflection points better than the payroll survey, found 589,000 job losses in December and still is not showing the improvement needed to signal a sustainable recovery.

An important new survey from the National Federation of Independent Businesses adds to these troubling statistics.

According to the NFIB survey for December, net changes in employment over the last three months stayed at minus-12 percent, with only 10 percent of business owners adding jobs and a full 22 percent cutting them. Looking forward, net hiring plans for the next three months come in at a seasonally adjusted minus-2 percent, up only one point from the November figure. And job openings notched up only two points in the survey, to 10 percent from the historic low of 8 percent, where the level had sat for the previous four months.

It thus comes as little surprise that small-business optimism has slipped back toward gloomy. The NFIB survey’s optimism index for December fell to 88.0 from 88.3, a setback from the general trend of improvement engaged when the index reached a cyclical low of 81.0 in March 2009.

In the NFIB survey, small companies were asked: “What is the single most important problem facing your business today?” Poor sales ranked first, at an all-time high of 34 percent. Why? A key factor could be the recent rise in government requirements, regulations, and red tape. An increased regulatory burden alters the economic environment, distracting small businesses from their core mission of sales and service.

The second biggest problem facing businesses today? Taxes, which placed second in the NFIB survey at 20 percent.

The fortunes of small businesses — perhaps more than any other commercial sector — are tied to rates of taxation on the individual. And individual income-tax rates are set to jump sharply at year-end when the Bush tax cuts of 2003 expire. Put another way, on January 1, 2011, the world’s biggest tax increase ever will arrive on the doorsteps of U.S. small businesses (and a great many others). Higher tax rates on incomes — along with capital gains and dividends — will reduce the incentive, on the margin, for entrepreneurs to engage in the kind of risks that lead to business formation, economic growth, and job creation.

There’s a monetary component to the small-business nightmare, as well — namely, the Fed’s ongoing near-zero-interest-rate policy.

Interest rates normally balance savers and borrowers. But when rates are held near zero, the environment becomes one of rationing a scarce resource — credit. It’s the same thing that happens when price controls are placed on a commodity, such as gasoline. A shortage is guaranteed since purchasers (or borrowers) are incentivized to buy more gasoline while producers (or savers), faced with lower returns, opt to under-supply the commodity. The Fed’s artificially low interest rate has a similar impact on the supply of credit available for small businesses.

The money supply (which includes cash plus the balances of checking and savings accounts) surged after the Lehman bankruptcy in late 2008. But money-supply growth has almost stopped today, meaning there’s no longer much incentive to add to a savings or checking account while the interest rates on them are stuck on zero. 

Correspondingly, inter-bank borrowing by small banks has fallen sharply. In part, this indicates lower demand for funds by smaller banks. But some of this decline reflects a rationing process. Why should one bank lend to another with rates this low?

As a result, the NFIB finds that loans are harder to get for 15 percent of independent businesses, the same level reported in November and just one point above the cyclical low of minus-16 percent reported in May 2009.

The net result is that the outlook for innovative, job-creating small businesses is shakier than normal.

In his State of the Union address Wednesday night, President Obama turned to the small-business dilemma, and suggested as fixes a small-business tax credit and the elimination of the capital-gains tax on small-business investment. Fine, but these adjustments likely will not do enough to fully reignite this vital sector. And the president’s plan to use bailout money to create a lending facility to spur banks to grant loans to small businesses smacks of the same excessive Washington intrusion into the private sector that scares off investment. The administration misunderstands the nature and magnitude of the problem.

These companies face a giant tax increase, reduced-credit conditions as a result of inappropriate monetary and regulatory policy, and more red tape from Washington, all of which challenge their ability to turn profits and hire workers. It will be very difficult for small firms to add jobs and take new risks while these disincentives are in place.

— David Malpass is president of Encima Global.

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