How Ohio's Budget Plan Could Boost Small Business

Ohio Governor John Kasich presents the fiscal year 2014-15 executive budget proposal at a news conference on Feb. 4 Photograph by Jay LaPrete/AP Photo

The federal government gets lots of attention for how its policies affect the health of small companies. What states do (or don’t do) is often overlooked, even though their policies matter, too.

That’s why I’m drawing attention to Ohio Governor John Kasich’s 2014-15 budget plan. His current budget’s unusual focus on small business is already raising eyebrows (and his previous economic policies have attracted controversy), but it should serve as a model for other politicians interested in increasing hiring and economic growth. Remember, small employers account for half of private sector GDP and employment, according (PDF) to the Small Business Administration.

What I find most appealing about the governor’s plan: It shifts Ohio’s taxes from a heavy reliance on income taxes and toward greater reliance on consumption taxes. Under the proposed plan, income tax rates would be cut 20 percent across all brackets, with the highest marginal rate falling from 5.925 percent to 4.74 percent, and the sales tax base would be broadened to encompass most services to make up the shortfall in revenue.

Many mainstream economists believe the economic distortions that taxes impose are smaller if governments rely on consumption taxes rather than income taxes. Income taxes penalize savings by reducing the financial return to invested capital, encouraging people to consume more and save less than they should. This excess consumption reduces the amount of capital available for investment, which in turn hinders innovation and lowers future living standards.

By shifting taxes to consumption, the governor’s budget reduces this distortion, bringing savings closer to the optimal amount for investment. Not only do small business owners benefit (as all taxpayers do) from the reduced economic distortions, they also benefit as borrowers from increased savings.

The governor’s plan also proposes tax relief for all owners of pass-through entities—sole proprietorships, S corporations, and partnerships—by excluding 50 percent of up to $750,000 of net business income from taxes. This tax cut will encourage business owners to hire and invest. Research (PDF) by Robert Carroll, an economist at the Tax Foundation, and colleagues shows that policies (such as an income exclusion) which boost small business owners’ after-tax income increase the odds that their companies will hire and make capital investments. Given the slow pace of small business investment and hiring in recent years, this incentive is a welcome stimulus.

Finally, the governor is offering tax relief to investors by allowing both active and passive business income to qualify for the exclusion as business income on personal tax returns. Cutting taxes on income earned from investing in small businesses is an important component to stimulating the sector because many growth-oriented entrepreneurs need outside capital to expand. This policy shift will encourage angel investors to take more bets, making it easier for growth ventures to raise money.

It’s a shame that Kasich is only the governor of Ohio. His plan would work even better at the federal level, where taxes are higher. Cutting state taxes, which are relatively small, won’t stimulate small business owners to hire and invest as much as cutting federal taxes, which are relatively large. And, of course, the governor’s plan only affects the taxpayers of Ohio.

But Washington might see Governor Kasich’s budget plan as a model that other states and the federal government can copy in their efforts to boost small business investment and hiring. And even if those in our nation’s capital don’t recognize the wisdom of the governor’s approach, he might take his plan to the city on the Potomac in 2016, after proving its merits in the Buckeye State.

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