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.

Day 7: Free Pancakes Around the USA!

I started out this morning by taking my 4-year-old son, Elijah, to the International House of Pancakes (IHOP) for the IHOP National Pancake Day, when IHOP gives away "short stacks" (servings of three pancakes) for free. In exchange, they have a collection on the way out the door for some local charity. IHOP has been doing this for five years, and it generates a lot of money for both IHOP and for the related charity. This is all IHOP restaurants across the country, so if there's one near you, go check it out ... and think about giving some to the local charity they're supporting.

At my IHOP, the local charity was First Choice for Women, which offers various types of support to women who find themselves in the midst of an unplanned pregnancy. Given the nature of the experiment, I felt like I should attend this event, but frankly my bank account is running a bit low, and I haven't gotten the first of the paychecks that I'm giving away yet (that comes Friday), so I didn't really have money to give away. Still, I figured I'd talk to the manager and get some information.

Elijah and I had the free pancakes, and some hash browns and sausage(which we were charged for), and as I was getting ready to pay the bill I realized I had a $100 bill in my wallet. Remember the pickup truck that I'd sold to a relative? Well, we'd gotten the first payment a couple of days before the project began and I hadn't really looked in my wallet since then.

To Give or Not to Give, That is the Question?
So here I was, in the middle of a giving experiment, having just been given free pancakes, with my son across from me, knowing that I'd have to go home and blog about this ... with a $100 bill sitting in my hand.

Dammit.

I paid the bill ($4.30) and then left a generous tip ($10.70), and was left staring at $85 in cash. A $50, a $20, two $5 and five $1 bills. And I did not want to give that money up. Some little voice inside me was declaring, "Listen, you're being more than generous, and you've laid out guidelines for how to do project. You do not have to give this money to prove anything to anybody. You got this money well before the project began. Just keep it."

But I didn't particularly trust these thoughts. The $100 bill had literally shown up right as a giving opportunity presented itself. Was I being greedy by not giving the money in this situation? What was the right thing to give in this situation?

Not trusting my own instincts, I had only one option. I asked Elijah.

I laid the money out on the table, and told him that the restaurant was collecting money to help women who were pregnant - just like Mommy had been just a few months ago - but who needed help paying for their doctor visits (he remembered Mommy going to the doctor a lot) and getting food and things like that. How much should we give?

Elijah reached straight for the $50, and then sat the $20 on top of it, then the $5 bills and then three of the $1 bills. Out of $85, I was left with $2.

Yowza!

I'm still, for reasons I can't quite put my finger on, feeling uncomfortable about this. There's the obvious, of course ... for me, $83 is a not-insignificant sum of money. That's about a month's worth of gas in my car, for example. But, of course, this money came to me as extra money from the sale of my pick-up truck. I wasn't planning for it and, frankly, I had enough money in savings to cover my expenses for the 40 days even without this $83. It really just made sense to donate it, yet I was mentally resisting.

Then Elijah began taking more ones, saying "I need change for my magic trick." And, sure enough, we had just learned a magic trick that involved turning a $5 bill into five $1 bills. So I took the $5 bill (which he also needed) and the five $1's and said, "How about we keep these to go in your magic kit?" (He got the magic kit from his Nana for Christmas. It's very cool, although he has some challenges really hiding the secret of the trick.)

So now I have $75 that I'm giving, and I'm still feeling a little hesitant about it. I stand at the donation box, feeling awkward, and Elijah looks at the money in my hand. He reaches out and fiddles a bit with the remaining $5 bill in it. On an impulse, I take the $5 out. Oddly, I now feel completely fine about putting the $70 into the donation box.

On the drive home, I think realized why I felt so awkward. Over the past two years, I have become nearly obsessive about tracking receipts for business expenses. I was giving a cash donation which I was giving as part of the 40 Days of Giving project ... which meant I would deduct it as a business expense, but had no receipt.

And, in fact, the cut-off expense where you need a receipt is $75.

In other words, if I had deposited $75 in cash, claimed it on my taxes as a business expense, and not had a receipt ... it's possible that, were I to be audited, the IRS could nail me for tax fraud! At $70, my understanding is that they have to take my word on it, but at $75 or higher I actually need the receipt. My subconscious may have been trying to let me know that I was about to get myself into a bit of trouble.

So it wasn't greed (Unless you count not wanting to be on the losing side of an audit as "greedy." This falls under my classification of "common sense."), and just to prove it (to myself, not to all of you people ... I'm not even sure if anyone is reading this far into the post, after all), when I got home, I gave the remaining $5 to Amber, so that she could get cookies for the other students in her afternoon Human Services class at Ivy Tech Community College. (She can't have any cookies, because she's going gluten-free in an effort to alleviate the baby's digestive problems. Talk about sacrifice!)

An illuminating exchange: 
I spent part of the day watching the kids and working from home, rather than taking a day off work (because our daycare fell through). At one point, frustrated that Elijah (let alone the baby, who can't help it) won't leave me alone to get work done, I said, a bit more loudly than was warranted, "Elijah, why can't you just leave me alone to work!"

He frowned and said, "I wish people couldn't make you work. You shouldn't give so much money away, because then you wouldn't have to work so much. Next time, you should keep it."

I do work a lot, on a wide range of projects ... and I am the sort of person who can lose himself in these projects, and focus on them to the exclusion of all else. I have to sometimes consciously remind myself that the projects are not the most important thing in life. Not even this one.

Being a parent is a tough balancing act. In part, you want to teach your kids to have a good work ethic, and to perform their time doing worthwhile things. But, at the same time, you want to be sure that your kids enjoy life and remember how important it is to play. I certainly don't want him to grow up with an emotional aversion to work.

But the truth is that I, too, wish that people couldn't make you work ... but even if I didn't have to work, I'd probably still choose to occupy myself with writing projects such as this one.

I hope that someday he finds a way to do work that feels like play.

Save on 2009 Taxes by Helping Haiti

Normally, if you itemize deductions you can save by including charitable donations to appropriate non-profit organizations. The problem with this is that, unless you're diligent about tracking your tax liability and change your W-4, so that your withholding is adjusted accordingly, you really don't see this as a benefit until as much as a year after you've given the donations. For people moved to donate in the wake of the Haiti earthquake - which has become the largest charitable giving activity performed by Americans at $518 million, even exceeding the amount donated following 9/11 - these deductions would take over a year to materialize, until people file their 2010 taxes.

Fortunately, it looks like Congress is actually doing something right, and has implemented a new rule that allows those donating to Haiti relief to retroactively include this deduction on their 2009 tax return, if they choose to. This means they could make the donation, file their taxes, and get the deductible amount in their tax refund in a matter of weeks. There's a limited window for when those donations need to be made to count on the 2009 return.

Note: This deduction applies also for donations of supplies and other property, but I strongly encourage people not to donate supplies. Getting these to Haiti just isn't efficient. It's better to give to charities like Doctors Without Borders or UNICEF, who have infrastructures and supply chains in place to get these supplies there quickly and efficiently.

Now, you have a choice ... instead of doing this, you can still include this donation in your 2010 tax return, which certainly makes sense if you already have low taxes in 2009 and are worried about your 2010 liability.

(I'm in this position, as I have research and promotional expenses from String Theory for Dummies in 2009 that largely offset my other income, but don't yet know what my income will be in 2010, largely because I don't know if 40 Days of Giving will actually get published - i.e. generate revenue - or not.)

Of course, for many Americans, itemizing doesn't really provide much benefit over taking the standard deduction, but for some it has a real impact ... and these are the people who, as a rule, have more income overall, and therefore likely have more discretionary income available to give larger amounts. If you are in that category, and you've given to Haitian relief, it may be useful for you to think about using this retroactive deduction to help offset your 2009 tax liability.

The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them by means which the law permits, cannot be doubted.

- United States Supreme Court (Gregory v. Helvering, 293 US 465)