Creative Taxing

>> Tuesday, October 11, 2011

Last time, I focused on the math that explained why lower taxes were actually a counter-incentive to hiring more people, all other things being equal. It's not just employment, but low tax rates are an encouragement to pocket money rather than reinvest it into one's own business. Money invested in one's own company, whether in the form of property, assets, employees, what have you, make the money active in the economy in ways that squirreling away (even if not in the Caymen Islands or Switzerland) does not. Employment, obviously, helps the economy, but so do the purchase of goods and services and property.

Money squirreled away in "local" banks is put to use in the form of loans which can be part of building business as well; however, as Relax Max would likely point out, a business largely built on credit is unlikely to be as stable and reliable as a company built on its own profit.

From comments on the last post, why higher taxes is an incentive to invest in one's own company is not clear, so I'll try to explain it again.

For any considerable profit (over and above a comfortable living expense), the tax rate impinges on that profit at a defined rate. If the goal is to command the maximum wealth (as opposed to give it to the government), higher tax rates provide more incentive to reinvest that profit into a company than lower taxes. It's a way of ensuring you keep your net worth, rather than hand it to the government. Again, this isn't an opinion; it's demonstrable fact.

Let me demonstrate: say the profit for a private company is 6 million. Now, at current rates, the maximum amount of tax that could be taken by the government is 35% (it's actually less, since lower levels are taxed at lower levels, but the higher the total, the more that savings is in the noise; also, over a the ½ million mark, it's all the same rate, so it's really only the excess' taxes we're talking about). That means the most one's taxes would be is ~$2.1 million, leaving the individual to go home with $3.9 million in his pocket. 2.1 mill is a chunk of change, but you're left with quite an asset as it is. However, if I reinvested some of the 6 million in my company rather than taking it as straight profit, the government would get less of it and my net worth (in the form of my company) would be greater. Note that doing so (if invested smartly) always leads to more net worth, even if the liquidity is less. I'll show you.

Net worth (owner) = Co(baseline) + 6 mil-2.1 taxes = Company baseline+ 4.1 mil
NW w/$2mil = Co(+2 mil) + 4 mil-1.4 mil = Co(b) +4.6 mil ($2 mil in company value)
NW w/$4mil = Co(+4mil) + 2 mil-.7 mil = Co(b) +5.1 mil ($4 mil in company value)

Now, if the tax rate is 80%, the incentive to invest increases:

Net worth=Co(B) +6 mil-4.8 million= Co(B) +1.2 mil
NW w/2 mil=Co(+2) +4 mil-3.2 mil= Co (B) + 2.8 mil (2 mil in company)
NW w/4 mil=Co(+4) +2 mil-1.6 mil= Co (B) + 4.4 mil (4 mil in company)

At a lower tax rate, I get an improvement in worth of 500 grand for every 2 million I invest in the company in my net worth. However, at a higher tax rate, my net worth improves by 1.6 million with every 2 million I invest in my company and, in fact, will have a better net worth than I would taking the profit at the 35% tax rate by reinvesting 4 million of my profit in my company.

Bottom line: an effective way to keep my wealth under my own control in a high tax environment is to reinvest in my company in assets and employees. Otherwise, it goes to the government.

Relax Max pointed out that, when the tax rate was very very high in the forties and fifties, rich people all knew how to keep their money. He's not wrong; this is one way they did it. That's why many significant people became really wealthy in this time frame: but not by sitting on relatively useless excess liquid (but taxable) wealth but by building assets that contributed to their net worth while still providing jobs and services, full of assets and investments. This is not a bad thing; this is how private industry is induced to provide jobs and help stimulate the economy - by forcing them to spend money to build their companies rather than fork it over to the government.

I hope that clarified things for the confused.

By that same measure, rock bottom tax rates for "capital gains" does the exact opposite of encouraging reinvestment into a company's growth. With capital gains topping out at 15%, getting beaucoup liquid assets through direct investment, the stockholder at a public company has more to gain bleeding a company to death in quick profits than he does in selling assets that have gained in value (due to reinvestment). A investor, in that case, could readily vote for quick profit decisions rather than decisions for the good and growth of the company (and massive layoffs or selling off assets are a quick and time-honored ways to create a tidy quarterly profit).

By keeping more money from interest and dividend than one does from labor, one discourages putting that capital to work except as stock. Nor do I understand that merit in it. Today, if I make $500,000 in "long term" capital gain, I walk away with $438K in hand.. If I "earn" it through labor, I'll only have $348K. Why send that message or make that distinction? What's the benefit? I'm sure RM has the answer to that.

Well, in theory, investing in stock provides investment into the company that would improve the value of the company, but that depends on how that stock is leveraged to drive decisions. If you like to buy and sell stocks, driving a quick profit, pocketing the dividends and then selling the stock at a high level until new buyers realize the company's been gutted can make for a pretty profit if one can just hold on to the stocks for a year to qualify.

There was a time when building a company for prosperity was the goal, when people's fortunes rose and fell with the success of their companies (instead of investors and upper management walking away millionaires from companies that fail spectacularly, leaving salaried and other workers unemployed, without insurance, their retirement funds gutted). If your company succeeded, you succeeded. If it failed, you went to the poorhouse with the rest of the poor slobs. You had an incentive to make it work, to make it a success.

Right now, I think (as in my opinion) our tax structure discourages making companies that last, investing in employees and assets. It is an opinion, but I base it on the fact that higher tax rates provide a better incentive for reinvestment into companies and that people are demonstrably greedy.

I'm stepping off my soapbox now. I didn't intend to demonstrate how higher tax revenues could address our concerns for our country's deficit as well as providing for more government jobs and the option to rebuild some of the crumbling infrastructure that made so much growth possible last century. But then, surely that's obvious.

Since I've been playing with taxes, next time I'll show conclusively how refusing to allow gays to marry is discriminatory, causing real financial damage, that should be unconstitutional.


  • Project Savior

    Nice Post.
    I read Relax Max's comments from last time and I'll try and do a little summary of your last two posts to help others understand.
    A company has two goals: Net Worth and Short term Income. Giving up a little Short Term Income by investing in the company leads to greater net worth.
    Apple and 3M are the prime examples of companies that look at Net Worth over Income.
    The current tax structure gives less incentive for companies to choose Net Worth and rewards those who look for Short-Term Income. The Gordon Geicos of the world.
    Companies looking for Net Worth hire more people per dollar earned, invest in equipment (which people have to make) and come up with new products that change the world.
    A higher tax rate rewards companies that look for a higher Net Worth. A lower tax rate rewards corporate robbers, those that gut companies for their resources.
    To sum up my summary, Higher taxes rewards productivity, lower taxes rewards destruction.

  • Stephanie Barr

    Nice summation.

    And all readily demonstrated with math. Ain't facts a bitch?

  • Shakespeare

    Are you sure you two aren't economists? Or CPAs?

    Or are you just geniuses.

    The closest I usually allow myself to come to math is grammar. Numbers make me edgy, even simple budget numbers. It seems you know what you're talking about, though, and I'm happy to see you blogging!

  • Project Savior

    Just a BA in it. Every once in awhile I like to use my $16,000 education.
    I did make a mistake in my post, I meant to call the investors that look for short term income by their proper name, Corporate Raiders not Corporate Robbers. But I don't think it matters that much.

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