How an employer-side payroll tax reduction will affect small businesses

The question of when jobs will return has been a recurring topic of discussion– with everyone eagerly awaiting the next jobs report and hoping for a glimmer of positive economic outlook. Albeit minimal, one encouraging trend is the consistent GDP growth. Likewise, interest rates have continued to stay low, commercial lending has increased, and inflation has remained manageable for the past few decades. Nonetheless, job creation remains slow.

Looking at recessions over the past forty years, a recovery in employment occurs (on average) nineteen months after GDP growth ends a recession. We are more than nineteen months out of the last recession, and while we have yet to see a recovery, we must also consider that this most recent economic downturn had a monumental impact on employment levels. It only makes sense that it would take a longer amount of time for the economy to improve. Outside of natural cycles in the economy, there are many externalities that can interfere with market stability, for example war, the deficit, international financial distress, etc. But most pertinent today is tax policy changes, particularly payroll tax policy.

In an effort to stimulate job growth, the most recent presidential proposal (The American Jobs Act) includes a reduction in payroll taxes for both employees and employers – from 6.2 percent each, down to just 3.1 percent each. President Obama’s plan would also eliminate payroll taxes for new hires and increased salaries, but the magnitude of that change is more difficult to predict than the rate reduction.

Not all employers in the U.S. contribute to new job creation equally. Out of the twenty-seven million businesses in America, only about 6,200 are publicly-traded. All others are privately-held, and many of them are small businesses. Small businesses drive approximately fifty percent of GDP and sixty-five percent of new job creation. Figures for privately-held businesses, including medium and large private companies, would be even higher.

To give the payroll tax reduction some context, the chart below illustrates the current impact that employer-side payroll taxes have on small businesses, those with annual revenue less than $5 million. The average small business currently spends an amount equal to at least twenty-two percent of their profits each year on payroll taxes for overhead employees. The full payroll tax expense is higher since this chart looks at G&A Payroll only. Since the profits/losses of small business owners are often considered to be personal income, hiring costs come directly out of their pockets, so to speak.

A change in employer-side payroll tax laws may lead to increased profitability of small businesses. The proposal mentioned earlier would increase the average private company profit margins by more than eleven percent, raising their average net profit margin to just more than six percent of revenue.

In an analysis of private company profit margins and the national unemployment rate, there is an inverse relationship. When profitability drops in private companies, they resort to layoffs to reach sustainable margins. So, at the start of the recession, margins dropped, and unemployment rose soon after.

Current data shows that private company net profit margins are continuing to increase. If the payroll tax cuts are implemented, profitability would increase tremendously, and employees would become significantly cheaper to bring on. Then, we might see the unemployment rate inch down more quickly and provide some relief to frustrated job seekers.