Fix debt, not taxes

When politicians talk about small business being the backbone of American prosperity, they are talking about people like me. Being an entrepreneur and creating jobs are worthy endeavors (and let's face it -- more fun than most day jobs). I'm very fortunate to have the education and temperament to do this -- and to live in a country that values taking risks and has set up a legal system that rewards success (e.g, patents and trademarks for original ideas) but doesn't punish failure (e.g., Chapter 11 reorganization, one of America's great competitive advantages).

There is a lot of debate right now about whether or not withdrawing tax cuts for 'rich' people will hurt economic growth. At the center of this argument are small businesses like my area franchise groups for Five Guys and NAKEDPizza.

My businesses, like many, have flow-through taxation, meaning that profits are taxed at personal rates; I pay taxes on my share of my company's income. Obviously, it is true that if more of our profit dollars are diverted to taxes, my partners and I will have less equity capital to re-invest in our businesses, or to spend on ourselves.

But if I really assess the numbers, there is little substantive difference to my business if the top tax rate goes from 35% to 39.6%.

Yes, more money paid to the government would pull some equity capital out of the business because we would have to allocate funds to pay for taxes.

The reality, however, is that this is much less important than the real problem: debt financing is nearly impossible to get, and it's getting harder.

Here's the math: I operate cash-flow businesses, which historically have been backed by both debt and equity (as opposed to software - nearly 100% equity). If I want to finance even 50% of a project with debt and that debt is unavailable at any price, it doesn't matter if some of my equity now goes to taxes instead. So in the simplest case where I own the whole business, if it makes $1M in profit and I am considering a $500,000 investment that will create the equivalent of 15-20 full-time jobs, the extra $30,000 in taxes (5% of the last $600k) I paid pales in comparison to the $250,000 I cannot get because the debt markets are shut.

This is why debt, not equity, is the fuel that really ignites economic growth.

This problem is only getting worse as $1 trillion worth of commercial real estate balloon payments come due in 2011 and 2012 on properties with high vacancy rates. My lender for Five Guys (BB&T) is an excellent partner, but when their overall capital ratios suffer, it doesn't matter that my business is successful. It turns out that we are only as strong as their weakest loans.

The SBA may end up with $30 billion in additional funding, but I'm not sure this is going to help much. The aggregate number of SBA loans is down, and anyway, most entrepreneurs have been required to provide personal guarantees (in the form of real estate) to backstop SBA loans. Never a good idea - see here. Also, the SBA provides a smorgasboard of programs based on one's status as a veteran, a member of a minority, or one's gender. A worthy idea but one often abused because the incentives to cheat are so high.

Like many issues we face today, this is a problem that more money alone won't solve.

As a capital-hungry SMB, what I wish is that we'd fine tune the SBA charter based on the "Race to the Top" model at the Department of Education. The SBA could create goals for small business lending and banks would apply to "win" guarantees or funding based on how successfully they fund small businesses. "Success" is defined as some combination of number of loans made, aggregate dollars lent compared to capital base, and importantly, loans made without requiring personal guarantees that rely on the same old sinking real estate.

The key is that not everyone would win dollars under such a system. Some institutions will be at the top and be eligible for SBA backstops, and some will strive but fail (which helps the SMB anyway), and some will choose not to play. But in the current system, nearly every small business loses as a falling tide sinks all boats.

From a tax perspective, the real win would be restructuring the tax code completely so that there is *zero* corporate tax, which both Robert Reich and Grover Norquist agree on. Taxes are borne by consumers eventually, and having corporate tax causes businesses to perform crazy short-term maneuvers (>$100B in lost output annually) rather than actually running their businesses for the long-term.

I'm all for having more money in my pocket rather than less -- I mean, who isn't? But let's cut government spending first (dinner) and then have a tax cut (dessert), especially when a tax cut really won't have a substantive effect on the real SMB that produces actual jobs. Now, back to work on that...