Small business has much to gain and very
little to lose if Congress establishes Social Security personal
retirement accounts. These accounts, which would allow taxpayers to
invest a portion of their Social Security retirement taxes, would
make capital more available to small businesses without adding any
appreciable administrative burden. In addition, since Social
Security benefits are more likely to fund a larger share of the
retirements of small-business owners, reducing the program's
impending financial problems is even more important to their
financial security.
WHY FOCUS ON SMALL
BUSINESS?
Small business exercises an immense influence on the American
economy. More than 99 percent of all U.S. employers are small, and
they employ just over 50 percent of the private-sector work force.
Such firms provide 75 percent of the nation's net new jobs and 50
percent of its private-sector economic output. 1
But
current statistics alone tell only part of the story. While larger
businesses tend to create process innovations that strengthen
economic efficiency, smaller businesses and entrepreneurs are
responsible for the lion's share of product innovations that
create new businesses and industries. 2 Technological
developments that are likely to play a central role in future U.S.
economic growth--such as biotechnology, lasers, and computer
software--have been closely linked to smaller technology
enterprises. This is an unusual feature of the American economy.
3 And it is not a new feature: A recent study of
Fortune 200 companies has shown that 197 of them could be
traced back to entrepreneurial founders. 4
Small firms also are blazing trails in the
rapidly globalizing economy. Between 1987 and 1997, the number of
U.S. small business exporters tripled to over 200,000, and these
companies were 20 percent more productive--with 20 percent faster
job growth and 15 percent higher wages--than the rest of America's
businesses. 5
At
the same time, small business traditionally has provided a portal
into the economic mainstream for younger and lesser skilled
workers, the economically displaced, immigrants, and people leaving
public assistance.
Consequently, Americans hold small
business in very high regard. A 1997 Gallup poll found large
majorities agreeing that small business represents "one of the best
ways to get ahead in America" and saying that they admired
small-business owners. Indeed, 92 percent of respondents said they
would be pleased if a son or daughter started a small business.
6 These survey findings are essentially constant across
age, ethnicity, gender, socioeconomic status, political philosophy,
and partisan identification, and they are significantly more
positive than the results of comparable surveys taken abroad.
Factors like these have led to an unusual
degree of political and partisan comity on many national
small-business issues. The substantial impact of small businesses
in a broad range of arenas strongly suggests that it is
economically, socially, and politically vital that small business
be helped--or at least not harmed--by decisions that are made
regarding the future of Social Security.
Reform should be crafted with a
recognition of the particular needs and vulnerabilities of small
businesses and entrepreneurs. These can be explored in terms of two
categories--concerns that affect the small business community as a
whole and those related to the operation of specific
businesses.
CONCERNS AFFECTING THE ENTIRE BUSINESS
COMMUNITY
The debate over resolving Social Security's coming financial
problems involves considerations that affect all small businesses.
In addition to concerns that would affect the day-to-day operations
of individual small businesses, some factors would affect the
entire small business community. These include:
- Greater
Dependence on Social Security for Retirement Income .
Employees of small businesses and entrepreneurs almost certainly
will be more dependent on Social Security benefits than those
entering retirement from larger enterprises. Most people in small
businesses do not have pensions. While 79 percent of mid- to
large-size businesses offer employer-supported retirement benefits,
far fewer smaller businesses do so. Among businesses with 25-99
employees, the figure is 46 percent; for businesses with 10-24
employees, it is 34 percent; and for those with one-nine employees,
it drops to 22 percent. 7
Despite efforts
to encourage Americans to save adequate funds for retirement, most
workers have not done so. Only 15 percent have saved more than
$100,000, and only 30 percent have saved more than $25,000.
8 While some of those with higher savings may be younger
workers, this still is very little money for periods of retirement
that are likely to span 10-20 years. Figures on personal savings
for retirement are not generally available by business size.
However, a study by the National Association for the Self-Employed
found that more than three-quarters (78 percent) of the
entrepreneurs it represents had saved less than $100,000 for
retirement even though virtually none of them had private-sector
pensions and their median age was 46. 9
With generally
inadequate pensions and personal savings, entrepreneurs would be
seriously and disproportionately affected by Social Security
benefit cuts--unless these cuts are offset by an increase in
personal accounts or other reforms. At the same time, such benefit
cuts would make retirement planning an even more daunting challenge
for small business. Many would surely turn away from
entrepreneurship in favor of "safer" choices--with damaging
consequences for the nation's economic openness, growth, and
innovation.
- The Impact of
Marginal Taxes . Entrepreneurs (who already face high
taxes) are probably more sensitive to changes in tax rates and tax
structure than wage-and-salary workers are. Entrepreneurship
entails risks, and those risks will not be taken without prospects
for rewards that the entrepreneur regards as adequate.
10 Policymakers in Washington seem to grasp the
importance of this "knife-edge" risk-reward calculus with regard to
capital gains taxes but seem to ignore it when other taxes are
being considered. Yet it is marginal tax rates--the taxes on that
"next dollar" of income--that the entrepreneur must weigh regarding
any and all revenue that cannot be treated as capital gains.
This
entrepreneurial calculus is apparent in a recent analysis of
Internal Revenue Service data on sole proprietorships. Recent
research indicates that a 5 percent increase in marginal tax rates
leads to a 10.4 percent decrease in the probability of investment
by those sole proprietors 11 and that marginal tax rates
that are high and progressive strongly discourage entry into
self-employment and business ownership. 12 Even the
current level of Social Security taxes substantially distorts
occupational choice and effort, as noted economist Martin Feldstein
has demonstrated. 13
Social Security
taxes already drive marginal rates above 40 percent for many
taxpayers. A taxpayer in the 28 percent federal income tax bracket,
for example, typically pays 5 percent in state income taxes and
15.3 percent in Social Security and Medicare taxes.
For
entrepreneurs, Social Security taxes are even more threatening than
income taxes. The entrepreneur must directly pay both the
employer's and the employee's share of the taxes and must do so
whether it has been a good year or bad year--regardless of what the
cash flows and accounts receivable may be, and regardless of
whether or not the business makes a profit. 14
Absent reform,
the Social Security-driven marginal rates for small-business owners
could well exceed 50 percent. Payroll taxes left on "automatic
pilot" would rise eventually by more than 33 percent, increasing
the annual taxes on a couple earning $50,000 by more than $2,000.
15 It would be hard to overestimate the damage this
would wreak on entrepreneurship and small-business ownership.
Marginal tax rates that are well above 50 percent for even the
smallest entrepreneur almost certainly would lead to a precipitous
decline in new business formations.
Like other
countries with punitive taxes on starting and running a small
business, the United States could expect to see the growth of a
large "informal" sector of entrepreneurial activity. As in those
countries, such "gray market" businesses would not be able to enter
into binding contracts, obtain loans or venture capital, advertise,
hire more than a few employees, offer those employees any legal
protections or mandated benefits, grow, or provide the government
with the kind of data it needs to make rational economic
decisions.
- Access to
Capital. Small businesses need better access to capital
than they historically have received. That is the resounding
conclusion of three separate White House Conferences on Small
Business over the past two decades. Hundreds of delegates to these
conferences, elected by small-business owners themselves, indicated
that "access to capital" was the number one small-business concern.
Later, in the
later 1990s, when this country's pace of business and technological
innovation became the envy of the world, it was the agility and
liquidity of American capital markets--exemplified by venture
capital companies--that were widely identified as a linchpin for
business development. While a large majority of small businesses
are started with private savings or personal loans, most small
business expansions depend upon banks and investors. For the whole
system to work, small businesses must represent comparatively good
risks for lending and investing, and sufficient capital to do so
must be available.
The decisions
that Congress makes on Social Security will have far-reaching
implications for capital access. A decision to do little or nothing
in the immediate future means that Social Security will not become
an even partially "prefunded" retirement program. Instead, it will
remain a 100 percent "pay-as-you-go" system. Its
multitrillion-dollar unfunded liability will remain unfunded.
Given the
country's likely demographic changes, additional debt and debt
servicing costs would be almost inevitable. Government borrowing
will compete with private borrowing and will almost certainly crowd
out some of it. Interest rates are likely to rise higher, given the
government's significant new demands on the capital markets, and
this in turn will raise small businesses' costs of borrowing. If
the political decision were made to use public debt to finance most
or all of the coming Social Security shortfall, that additional
debt would rise by approximately $47 trillion by 2075.
16
Moreover, unlike
borrowing to finance a transition to a prefunded system, borrowing
to maintain the current system could never be repaid from Social
Security tax receipts. The existing debt load exceeds $10 trillion,
and the system's "pay-go" structure would continue making it
larger, given the demographic shifts underway in the U.S.
population.
Such an
open-ended borrowing approach also would risk substantial
inflation, in addition to which the sheer scale of the fiscal
irresponsibility inherent in that approach could jeopardize the
dollar's international standing in denominating debt and also as a
"reserve" currency.
Financing Social
Security debt out of general tax receipts (largely income tax
receipts) most likely would lead to significantly higher income tax
rates. As noted above, higher marginal tax rates are a serious
hindrance to entrepreneurship and business ownership. Higher taxes,
like reduced Social Security benefits, would take money from the
pockets of individuals and companies, thereby shrinking personal
savings and retained earnings as sources of capital.
But the United
States need not pursue this ominous scenario of fiscal
dead-ends.
A "VIRTUOUS CYCLE"
Allowing Social Security recipients to place a portion of their
taxes in personal accounts that they own and control would initiate
a "virtuous cycle" for capital markets.
For
one thing, it would begin reducing trillions of dollars in unfunded
liabilities, 17 which would create a favorable climate
for balanced budgets or surpluses. If the experience of the past
few years is any indication, federal budgets that have surpluses
instead of massive deficits are good for small-business capital
needs. Since 1998, small business has enjoyed the best access to
capital on record, according to economic data tracked by the
National Federation of Independent Business. 18
For
another thing, creating personal accounts would have an effect not
unlike creating employer-provided pensions. Capital would build up
and would be put to productive use. Small business would
benefit--directly, through investments from the funds themselves
and, indirectly, through transactions with financial service
intermediaries with access to the funds. This process is succinctly
summarized in a World Bank survey of global pension reform:
[P]ension funds
are critical players in "symbiotic" finance, the simultaneous and
mutually reinforcing presence of many important elements of modern
financial systems. They can support the development of factoring,
leasing, and venture capital companies, all of which specialize in
the financing of new and expanding small firms. 19
The
experience of Chile is instructive in this regard. Chile's Social
Security personal account system is the world's oldest, dating back
20 years. Since then, the country has sustained robust economic
growth averaging 7 percent a year, and both its capital markets and
small businesses have flourished. 20 Among the more than
30 nations that have adopted personal accounts since then, none has
reported a contradictory economic experience.
Perhaps most important, personal accounts
would dramatically improve the rate of return that entrepreneurs
could expect on their payroll tax payments and thereby enhance
their retirement income. Some of the most persuasive evidence of
this dynamic is found in an analysis of the University of
Michigan's long-running Panel Study of Income Dynamics. The
analysis carefully tracked more than 200 independent business
owners over a 35-year period. It showed that they could expect
rates of return averaging about 3 percent to 3.5 percent within the
Social Security system (in contrast to a 7 percent historical rate
of return on equities). Over a working lifetime, 92 percent of the
business owners would lose between $300,000 and $700,000 if they
were to pay Social Security taxes rather than invest the same
amount in a conservative portfolio of 50 percent blue chip stocks
and 50 percent long-term government bonds. 21 Brighter
retirement income prospects for small businesses and entrepreneurs
would allow more people to take the many other risks that
small-business ownership and entrepreneurship entail.
In
sum, personal accounts offer two fundamental macroeconomic
advantages for small business: what the government would not do
(unnecessarily raise taxes, cut Social Security benefits, or
borrow) and what the private sector would do (build up and deploy
capital and improve retirement incomes).
The
foregoing discussion has touched on four of the five basic options
that the government could utilize to address Social Security's
future financing needs. A fifth option would be to reduce other
government spending sufficiently to cover Social Security's
expected funding shortfalls.
Normally, this option might interest many
small businesses, but the scale of the spending reductions
required--perhaps $30 trillion to $50 trillion over time--renders
it completely unrealistic. Funding for entire functions of
government--for example, veterans programs, the administration of
justice, transportation, space exploration, environmental
protection--would have to be redirected. In 1994, in spite of the
powerful mandate for belt-tightening evidenced by the Republican
landslide, Congress barely summoned the political will to
extinguish the Pennsylvania Avenue Development Commission. It would
be utter fantasy to assume that Congress would opt to abolish
entire departments on the scale of Transportation, Environmental
Protection, or Veterans Affairs rather than borrowing, raising
taxes, or cutting Social Security benefits.
Even
if this were possible, moreover, it would send the wrong message:
that every function of government should be subordinated to the
imperative of providing retirement benefits. That is not a message
that small-business owners (or, for that matter, any group of
Americans) should want to be sent. As a prominent Democratic Party
journal put it:
[Democrats opposed to Social Security reform]
should drop the motto "Social Security First" and start using
"Social Security Only"--it more accurately reflects their
position's logical endpoint. Democrats must ask themselves whether
every other issue they care about--inner-city poverty, public
schools, the environment, job training, universal access to health
care--should be sacrificed or starved to maintain [today's] Social
Security. If raising payroll taxes is part of the solution, exactly
how much of a burden in regressive taxes on low-to-middle income
Americans are Democrats willing to tolerate?
22
CONCERNS REGARDING OPERATIONS OF INDIVIDUAL
BUSINESSES
The debate about Social Security reform also entails
concerns regarding day-to-day business operations, one of which is
the purported administrative burden that personal retirement
accounts would place on small businesses. 23 Before
examining the substance of this assumption, it should be noted that
major small business associations in the United
States--associations that presumably have had ample time to study
the issue--have been strongly urging Congress to enact personal
accounts for years. 24
While the "small business administrative
burden" avenue of criticism has helped to identify various
practical issues relating to the implementation of personal
accounts, these critiques often overlook or misinterpret the
approach entailed by the most widely accepted current proposals for
personal accounts, which minimizes the administrative burden on
employers. 25 Most of the current proposals for personal
savings accounts do not require employers to:
-
Select investment
funds or fund managers for their employees;
-
Set aside or
independently deposit any funds;
-
Transmit any
funds to workers;
-
Separately
transmit any funds to the federal government;
-
Frequently submit
information relating to personal accounts;
-
Choose annuities
for workers; or
-
Bear legal or
fiduciary responsibility for the performance of any of their
employees' investments.
In
fact, the proposals generally follow the example of the Thrift
Savings Plan that is currently available to federal government
workers. Under this scheme, a portion of the employees' Social
Security taxes would automatically be reserved by the Treasury
Department for Social Security. This money would be deposited by
that agency or the Social Security Administration into a "default"
fund, indexing a large number of stocks, or purchasing low-risk
Treasury securities, or both. As these accounts reached a specified
size, workers would be given the option to choose from a group of
carefully selected and regulated investment options. They, and not
employers, would most likely do so by checking a box on a form at
the time of employment or subsequently. 26
As
for the employer's "administrative burden," the most that any of
the current proposals entail is an annual reconfirmation of the
"box" that employees have checked. Employers who want to do more
may do so. For example, under recently enacted law, employers may,
if they choose, offer free investment advice to employees, and this
advice is not treated as a taxable benefit. 27
Indeed, it is significant that opponents'
claims that private investments would bring excessive
administrative burdens to employers (a potentially explosive
criticism) have done little to reduce the strong support that
small-business owners and entrepreneurs have registered for
personal accounts. In one survey, the respondents were asked how
they felt about being "required to help administer a Social
Security account system" and whether they would be willing, at the
extreme, to spend up to $1,000 per employee per year to implement a
personal account system. 28 In another survey,
respondents were told that employers would have to "separately
deduct" the amounts for personal accounts and "deposit" these
deductions "in a different place" from the taxes that are normally
withheld for the federal government. 29
Yet,
despite these misleading or false assumptions regarding likely
administrative burdens for employers, the majority of respondents
to both surveys still favored personal accounts. Indeed, only 20
percent were less enthusiastic after having been told, in the first
survey, that they would shoulder a significant administrative
responsibility for the system. Only 16 percent found the "separate
deposit" procedure described in the second survey to be a "very
serious new burden"; 41 percent said it was "not very serious."
To
anyone familiar with small businesses' typically strident reaction
against government-mandated paperwork, these survey findings are
nothing short of astonishing. They suggest not an ambivalence
toward Social Security reform, but a powerful depth of conviction
favoring it.
Although the survey questions described
above may have been the result of genuine uncertainties about how
personal accounts modeled on the federal Thrift Savings Plan (TSP)
would work, descriptions of employer responsibilities given by
opponents of Social Security reform have often been intentionally
exaggerated and distorted. The truth is that the administrative
"burden" on small businesses would be very minor under such a TSP
approach and that small businesses stand to benefit substantially
from Social Security reform that includes personal accounts.
CONCLUSION
The energy invested in attempts to mislead small-business owners
regarding Social Security reform should be countered with efforts
to provide leadership on this issue. That is the task of those who
favor personal accounts. They may find inspiration in the words of
President Franklin D. Roosevelt:
Social Security is a "development towards
[a] goal, rather than a finished product. [W]e should be constantly
seeking to perfect and strengthen it in the light of our
accumulating experience and growing appreciation of social needs."
30
James Morrison, Ph.D., has specialized in small
business and entrepreneurship policy for more than 20 years. He has
worked for Congress, government agencies, international development
organizations, and small business trade associations.
Endnotes