The “Crowding-In” Effect, Or, If Washington Wants To Help Small Businesses, Maybe It Should Borrow On Their Behalf

As I write this the US Treasury market seems to be providing a way for the government to put some money where its mouth is and do something meaningful for small business.

First, we’ll need some background. Throughout the debate on extending tax cuts to individuals making over $200K, many prior to this writing have pointed out that to not do so amounts to a tax hike on small businesses, with such firms accounting for around 60% of recent job creation in the United States (the increase would kick in at $250K for couples, about the combined salaries of two professors in a major metropolitan area, who would I’m sure be surprised and excited to learn they are now considered among the mega-rich). Indeed, by some estimates, to not extend the cuts would in fact raise the tax on half of all small enterprise income in the country Some argue, a bit disingenuously, that only 3% of small business would be affected, but that’s only because most small firms make little or no money at all; the tax increase would hit hardest that minority of entrepreneurs who in this anemic economy are doing well enough to have some hope of hiring.

And while there is a case to be made that tax cuts for lower earners more efficiently translate into short-term stimulative spending, it’s the saved and invested tax cut dollars of higher earners that tend to fuel longer-term growth in business and hence job creation.

Those in favor of this tax increase point to the ballooning national debt, arguing the country can ill afford tax relief for the entrepreneurial. Using some numbers to put this claim into context might be helpful. Not raising taxes on the so-called higher earners would cost an average of $70 billion per year over 10 years, or $700 billion. That’s about 23% of the $3 billion 10 year cost of extending the cut to the rest of the country (as proposed by the Administration), and well under the $814 billion cost of the stimulus package whose efficacy has been, shall we say, underwhelming.

Given how small the cost of tax relief on those most likely to invest would be when compared to the giant debt rung up over the past two years and the massive borrowing currently proposed, there is little logic in raising taxes on people managing some level of entrepreneurial success in this difficult environment. The truth of this is made especially clear upon consideration of one of the few silver linings to be found in the dark clouds of our economy, that being the government’s remarkably low cost of borrowing.

While risk aversion has abated since the depths of the crisis, many market participants continue to seek the safety of US Treasuries, thanks to a witches’ brew of fear including that of European sovereign and US municipal defaults, real estate overhangs, malfeasance real and imagined and yes, expanded regulation and higher taxes. Pervasive dread has pushed vast capital out of risk markets and into US government debt. You can think of this as the causal obverse of the famous “crowding out” effect, in which increasing government indebtedness pushes other would-be borrowers and those seeking equity investment out of the market. In the present case, the withdrawal of fearful capital from other forms of finance has created a vacuum into which ever vaster quantities of Treasury debt are sucked in, allowing the debt of the nation to be financed at rates at which most small businesses can only dream of borrowing. The past and potential purchases of Treasuries by the Federal Reserve under the banner of stimulative “quantitative easing” has (so far) served to further lower the yields on Treasuries. As of this writing, yields on 10 and 30 year Treasuries are about 2.5% and 3.75%, respectively, and this at a time when the implied inflation rate based on inflation-protected “TIPS” bonds is between 1.75% and 2.25%, making the expected real return on Treasuries slim indeed.

Thus the Treasury could fund tax relief for small businesses by effectively borrowing on their behalf at long-term fixed rates unattainable by them on their own, allowing the income of those enterprises to be reinvested. At these low fixed rates, with luck and limited further economic mischief in both the public and private sectors, there’s a reasonable chance the return on that capital will substantially exceed the cost of financing, facilitating the service of the added debt through the taxation of profits.

Some will complain this prescription further elevates a borrowing trend which is long-term unsustainable. I agree, but the increase is slight compared to the overall growth in the debt, which will in the end have to be addressed by other measures, including (dare I speak its name?) spending cuts, even in entitlements. Others will note the increase in Treasury issuance and the Fed’s purchases of same raise the specter of debt monetization, potentially driving up rates, weakening the dollar, and increasing inflation. Again that is true, but, the fact remains right now the world is willing to let the US lock in its financing at rates that seem to ignore this possibility.

Finally, there are those who will say I propose using the public credit to gamble on American entrepreneurship. Perhaps so, but given that we just bet over eight hundred billion dollars on, amongst other things, Amtrak and a combination of Chrysler and Fiat, I’d say my proposed wager is hardly the most speculative the nation has been presented with. Its time to give small business a chance.

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