Skip to comments.Business 201: Why Low Tax Rates Matter
Posted on 11/26/2012 8:33:10 AM PST by Shout Bits
With Pres. Obama's reelection, political stem winders are focused on 'The Fiscal Cliff,' as the enacted package of reductions in the growth of government and tax increases to above Clintonian levels is called. Few Republicans are willing to play hardball and face sequester, but at least some are insisting on new revenues through eliminating deductions rather than raising marginal rates. While Shout Bits is certain Congress will find a way to do worse than just driving off the Cliff, here is a primer on why keeping marginal rates low is important for everyone.
Money never rests. Apart from the wad of cash in America's pockets (M0 which is .8% of all cash like instruments), every dollar is invested toward economic growth. Even those who simply put their cash in checking accounts are allowing their banks to lend that money to businesses and homeowners. While some of the upper-middle class, whom Obama calls 'rich,' keep their money in banks, many invest their cash in businesses directly.
Perhaps what Obama does not understand is that business cannot grow without reinvestment of its earnings. Growth cannot happen without investment; it is not magical. Long term, without raising outside equity (i.e. issuing new shares of stock), a business can only grow at the rate of its return on equity (assuming no dividends). Whenever a business raises new equity capital, that money comes from other less profitable sources, so new investments are a zero sum game at the macro level. Growth comes only from reinvestment of return on equity (which further explains why QE3 and stimulus can never work).
To achieve growth, therefore, return on equity should be maximized. Investment analysts often look to the DuPont Equation:
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity) To save Shout Bits's readers the headache of interpreting the equation, it basically says ROE is maximized by running a tight ship, applying assets carefully, and selling the most profitable products. Also, Net Profit is after tax, as there are no accessible pre-tax profits (i.e. the government gets its cut first). Assuming businesses are trying as hard as they can to maximize the components of the DuPont Equation, the remaining variable is taxes.
If tax rates go up, ROE goes down, slowing growth. Greed, as Obama calls it, has nothing to do with it. The 'rich' do not keep their money in mattresses, they reinvest it in growth. The one thing the 'rich' like to do is get richer. While Obama may hate capitalists and seek "revenge" and "punishment" against them, they are also the source of economic growth, which the US desperately needs.
This is why, if the government must have more tax dollars, eliminating deductions and preferences is the better way to go. Especially in the corporate realm, tax preferences are a way to enhance growth at the expense of others (assuming the tax preferences are paid by raising marginal rates or marginal rates could be lower without the tax preferences). Those who lobby well are allowed to grow faster than those who focus on less valuable tasks like serving consumers.
Gov. Romney's proposal to keep the Bush tax rates but cap total deductions was a pleasantly pro-growth proposal. It limited the amount by which the well-connected could achieve earnings growth compared to the non-political class. Overall, such a proposal would grow the economy faster than one with high rates and innumerable preferences. Some Congressmen from both parties have teed up Romney's concept.
Low marginal rates are not a favor to the rich, although they obviously would benefit. Low marginal rates are a pathway to economic growth and thereby better employment for the ordinary citizen. Not a theory, but solid well tested math, low tax rates, higher ROE, and economic growth are all tied together. Voters should encourage GOP leaders to negotiate toward keeping rates low as they cut a deal with Obama over the Fiscal Cliff.
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But it is typical of the government to do the stupid thing. In the 1970's during the "energy crisis," the government, in addition to imposing price controls on oil, acted to further restrict oil company profits and thus oil industry investment, by punitively increasing their rate of taxation precisely by first reducing and then totally abolishing the customary depletion allowance on crude oil. The effect was a further blow to domestic oil production.
What difference does it make whether you raise the marginal rate or eliminate deductions? The net effect is the same either way. If a given company pays on a net taxable income of $100,000 at a 35% rate their tax will be $35,000. If you eliminated $10,000 of deductions they would pay, at the same 35% rate, $38,500. Where’s their incentive to spend (deductible) money to grow their company and bottom line?
At least when rates are raised deductions are worth more and greater incentive is created to spend deductible dollars.
for sake of argument, let’s assume that both parties will pay $35K in taxes on $100K in income. One pays a higher rate with deductions, while the other pays 35% with no deductions.
The issue is incentives at the margin. For the first person, the 100,001 dollar is taxed more than for the second. The second person is free to reinvest more of the 100,001st dollar and thereby create growth.
One system encourages continued production, investment, and growth. The other (high tax) encourages consumption and capped production.
Encouraging consumption is the underlying flaw in Keynesianism. He confused consumption with wealth creation. Low taxes encourage wealth creation which is the true proper goal. Simple consumption, which tax preferences encourage is not usually the best allocation of resources to encourage the social goals of economic growth and employment.
But some consumption can create wealth. For example, I have clients that own restaurants. If they spend money remodeling a store that spending reduces their taxable income, especially if they are able to use the Section 179 expense deduction. I fully expect the law will change for that deduction allowing only the smaller businesses to take advantage of it. If my clients remodel their stores, the remodels generally lead to increased sales, which increases their wealth if they manage those sales wisely.
The Keynesian flaw you mention is more akin to the flawed thinking I see where some are encouraged to mortgage their home only because they can deduct the interest. That kind of consumption leads to decreased wealth.
I agree that lower rates is the better solution, but try getting that through the static thinking brain of a democrat.
Remodeling a store is an investment, not consumption.
I am sure that among the many thousands of tax preferences in the current code, there are occasionally people who use them to make wise investment decisions that would make sense anyway. That is, in my guess, the extreme minority of cases.
If remodeling a store makes sense economically, then it will happen under a low rate environment without preferences just as it would in a high rate environment with preferences.
Thanks very much for your comments, BTW.
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