Monday, November 21, 2011

Tax on Businesses: Some Numbers Crunched

Today, it looks like the "Super Committee," which was tasked with making a $1.2 trillion reduction in our national debt, will fail. Though a lot of different messages have been coming out about why this group failed (among them, apparently, the startling revelation that John Kerry talks too much), certainly one sticking point has been that conservative members of Congress are uniformly opposed to any sort of repeal of the Bush era tax cuts.

Do Tax Cuts Hurt Business Investment?

This obsession with tax cuts has always struck me as peculiar. The basic argument seems to be centered around the idea that tax cuts on the wealthy and on corporations result in freeing up more money for corporate growth and job creation. But I question this. A couple of months ago, I got into a discussion on a friend's Facebook page on just this topic and made the following comment:
I always wonder ... Who are these job creators who would be hiring, but are afraid they can't afford their taxes? I always hear things like, "Businesses can't afford to hire more people and/or expand their business because of their tax burden" ... except that any sort of business expansion comes off the top, BEFORE TAXES. If you want to expand your business, doing so incurs no tax burden whatsoever, doesn't it?
One person on the thread responded with what seemed to be a reasonable explanation:
Lets say that your profit margin is 10%. You have decided that it will cost you 2% of that profit to hire a new employee with the goal of expanding business. If your tax rates might go up in the next year or two that will reduce your profit margin enough to eat up most or all of the cost of that new hire, you might decide to wait until you either know for sure that your taxes are, in fact, going up, choose to hire anyway, or decide not to go for it. Its most likely the uncertainty that is keeping those folks on the sideline (are the Bush tax cuts expiring? Are they not? etc)
There's an instinctive logic to this argument. If the amount of money that you have goes down, then surely the amount you have to spend on your business is going to drop. Surely, it hurts this reinvestment to increase taxes, right?

Some Tax and Growth Scenarios

This conversation took place a good two months ago, but it's been sticking in my craw since then. Something about the numbers just didn't sit right, so I decided to actually work it out. Let's consider this situation from multiple different scenarios:

Scenario A: 35% corporate tax

This is the current scenario, as outlined by the individual above. The total net profit of the company is 10% of the total revenue the company brings in. Working backward from that, some quick math shows that, at a tax rate of 35%, we get the following as percentages of total revenue:
Business expenses: 84.61%
Profits: 15.39%
Taxes: 5.39%
Net Profit: 10%
Scenario B: 38% corporate tax

If the only change is an increase of 3% on the corporate tax rate, but the total revenue brought in remains constant, then we get:
Business expenses: 84.61%
Profits: 15.39%
Taxes: 5.85%
Net Profit: 9.54%
Scenario C: 35% corporate tax + 2% investment in growth/new jobs

Now, let's consider the situation where the business wants to expand their operations (including hiring some new employees) by reinvesting about 2% of their revenue into expansion:
Business expenses: 86.61%
Profits: 13.39%
Taxes: 4.69%
Net Profit: 8.7%
Scenario D: 38% corporate tax + 2% investment in growth/new jobs

The final scenario is the one which, according to economic conservatives, would be unlikely to happen. Scenario C is the one they think is very likely - leave taxes alone, and businesses will be motivated to invest and create jobs. If, however, you increase taxes by 3%, then the numbers that follow are so intimidating that businesses would rather stick back in Scenario B than move forward.
Business expenses: 86.61%
Profits: 13.39%
Taxes: 5.09%
Net Profit: 8.3%

Assumption: Constant Revenue

Now, before delving into these numbers too deeply, let's consider the implications of keeping the revenue the same in all these scenarios:

1. That business in scenarios 3 & 4 is re-investing an extra 2% of their revenue back into the business. Presumably, this is being done with a plan to expand their business operations and, in turn, increase their total revenue. Still, it's possible that these plans will take a while to pay off, so it's realistic to assume that they'll have to front this money for a while without seeing benefits from the work.

2. The business in scenarios 2 & 4 exists in a world with a 38% tax rate, so it's possible that the overall effect of this tax rate drags the economy down a bit (as economic conservatives claim) and, in turn, lowers their total revenues or increases non-tax expenses in some unforeseen way. Still, this claim is highly speculative and I don't know a good way to put a number on how the economic impact of 3% taxation would affect this hypothetical company, so I just assumed the total revenue stayed constant.

The Analysis

Back to the actual numbers, then. You'll notice that despite the fact that they've reinvested 2% of their total revenue back into the business, in none of these scenarios does their Net Profit drop by 2%. This is because, as I mentioned in my Facebook quote earlier, businesses operate from a very favorable tax position: they pay their expenses before they pay their taxes. Individuals don't have this option (usually). If I spend 2% of my money on a personal item, I have to pay the full tax on the 2%. This means that for someone in the 10% tax bracket, who has a job where they pay 7% into Medicare & Social Security, each dollar they get comes with a 17% tax on top of it.

An individual spending 2% of their gross income on their needs, therefore, actually has to take 2.17% of the total money they've earned to do it (excluding sales tax). A corporation spending 2% of its gross income on its needs costs a mere 1.3% of the revenue that it's brought in. This is assuming the tax rate stays consistent at 35%, of course. An increase of 3% taxation means that 2% costs the company a whopping 1.7%.

This, incidentally, is why every individual should have their own home-based business in something they're passionate about.

There are a number of ways to consider these numbers, and choosing which one is largely based on your political stance.

Interpretation 1: Tax Increases Cost Money

Scenario B results in less net profit than scenario A and scenario D results in less net profit than scenario C, so a conservative would argue that the increase in taxes causes a drop in the profit earned by the company (and, as a result, by the individual shareholders). This is a perfectly valid interpretation and fits the facts, although it is a very narrow interpretation, completely ignoring any potential benefits from a 3% corporate tax increase.

Interpretation 2: The Tax Incentive

The problem is that conservatives don't just argue that the corporations will lose money, but also that it will be too expensive for them to invest in growth if their taxes increase. This doesn't hold up with these numbers, however. In the above scenario, if the taxes stay at 35% it costs 1.3% to reinvest 2% into their business. If the tax is raised by 3%, however, the drop from 9.54% to 8.3% is 1.24%.

Why does this happen? Because, again, businesses pay taxes based on their after-expense income.

In a sense, lowering taxes actually gives less incentive to growth, because as a percentage, reinvesting in the business doesn't get you as much bang for your buck.

Interpretation 3: The Growth Incentive

Keep in mind that the overall goal we want is to have businesses grow, meaning that either Scenario C or D is preferable to either Scenario A or B. It turns out that getting the 2% is what causes the big penalty to the net profits, not the 3% tax on profits.

Still, the fact is that - taken by itself - the 3% tax increase makes it just a little bit less cost-effective, in absolute dollar terms, to take the risk to grow your business.

But then, the point of raising taxes wasn't to promote growth ... it was to increase tax revenue. The argument that it will instead drive down growth just doesn't seem particularly justified, at least based on this particular example. If the business wants to grow, the 3% increase in taxes just doesn't have much bearing at all.

Wednesday, May 18, 2011

Education, Building Community, and Individual Growth

Education is one of the most important things that we can do as individuals or as a society. Through education, the mind is transformed, given the nourishment to explore new avenues of thought.

A quality education isn't just the province of teachers and the students, as much as we'd like to relegate it to them. It is something everyone has to take part in, throughout an entire community. Booker T. Washington High School in Memphis, Tennessee, is a school where the creation of a supportive educational community has led to amazing things, as recently cited in Barack Obama's commencement address (read the speech or watch the video).
Just a couple of years ago, this was a school where only about half the students made it to graduation.  For a long time, just a handful headed to college each year.  But at Booker T. Washington, you changed all that. 

You created special academies for ninth graders to start students off on the right track.  You made it possible for kids to take AP classes and earn college credits.  You even had a team take part in robotics competition so students can learn with their hands by building and creating.  And you didn’t just create a new curriculum, you created a new culture -- a culture that prizes hard work and discipline; a culture that shows every student here that they matter and that their teachers believe in them.  As Principal Kiner says, the kids have to know that you care, before they care what you know.  (Applause.) 

And because you created this culture of caring and learning, today we’re standing with a very different Booker T. Washington High School.  Today, this is a place where more than four out of five students are earning a diploma; a place where 70 percent of the graduates will continue their education; where many will be the very first in their families to go to college.  (Applause.)
I discuss some of the intellectual benefits of education elsewhere, but here I'd like to focus on even more ephemeral benefits of education, including some which matter even more than better mental acumen. President Obama goes on to highlight these ideas as well:
And finally, with the right education, both at home and at school, you can learn how to be a better human being.  For when you read a great story or you learn about an important moment in history, it helps you imagine what it would be like to walk in somebody else’s shoes, to know their struggles.  The success of our economy will depend on your skills, but the success of our community will depend on your ability to follow the Golden Rule -- to treat others as you would like to be treated.

We’ve seen how important this is even in the past few weeks, as communities here in Memphis and all across the South have come together to deal with floodwaters, and to help each other in the aftermath of terrible tornadoes.

All of these qualities -- empathy, discipline, the capacity to solve problems, the capacity to think critically -- these skills don’t just change how the world sees us.  They change how we see ourselves.  They allow each of us to seek out new horizons and new opportunities with confidence -- with the knowledge that we’re ready; that we can face obstacles and challenges and unexpected setbacks.  That’s the power of your education.  That’s the power of the diploma that you receive today.
You can see the impact of this way of thinking resonating from Obama's education - both his formal education and his family life - but I think that Michelle Obama's story is even more relevant, because it seems to have taken her longer to realize the course that she wanted her life to take. In a recent college commencement address in Iowa (with video also available), Mrs. Obama outlines the path her own life took as she searched for inspiration:

... that process of discovery doesn’t stop when you leave this campus.  I know that from my own experience.  Back when I graduated from college, I was certain that I wanted to be a lawyer.  So I did everything I was supposed to do.  I got my law degree.  I went home and got a job at a big firm in Chicago.  By all appearances, I was living the dream.  But the truth is, all the while that I was climbing, I knew something was missing. 
Sure, I was working up in a tall building downtown, but when I looked out across the skyline of the city, even though I could see the community I’d come from off in the distance, I was so far up, and so far away, I couldn’t feel that community.  I felt like I was beginning to lose that connection to where I had come from.  And I realized that I didn’t want to climb anymore.  I wanted to be grounded, working with the folks that I knew, folks like the ones I grew up with.  I wanted to be mentoring young people, I wanted to be helping families put food on the table and a roof over their heads, I wanted to be giving folks the kind of chances that I’d had. 
So I did something that shocked my friends and family, and added about a decade onto my student loan debt: I quit that job. I left that high-paying firm to go work for the city government.  And from there, I moved on to lead a nonprofit organization called Public Allies, helping young people pursue public service careers.  I wasn’t making nearly as much money and my office wasn’t nearly as big or as nice, but I was working with terrific young people and colleagues who inspired me. 
I found that I would wake up every day with excitement, with a sense of purpose and possibility, because I was finally doing something that made me feel fully alive.  And graduates, that’s what I wish for all of you today – for you to find that career, that calling, that makes you feel alive.
What I like about this passage is that it is supportive of education while also pointing out that just getting advanced degrees for their own sake will not lead to happiness or fulfillment. You have to really find the things that you love and then pursue those. College degrees, and even advanced degrees, may lie along that path, but they may not.

Whatever one's views of the Obama's political objectives, the course of their life is certainly inspirational, especially for anyone who wants to work to serve others. Their overwhelming commitment to the goals of education should be commended, even by those who normally like to focus more on fiscal concerns. An educated populace is the best defense we can have against a failing economy in the future, while a failing educational system will devastate every aspect of our society.