Wednesday, February 01, 2006

Tax cuts increase revenues? redux

One of the problems with those who make this argument is that they don't think it through - they take it almost as an article of faith. Some even misapply a step. Let's take a real solid look at how it works, and debunk a couple of arguments along the way.

Let's start with our sample company. It sells widgets. It has $100million in assets. Due to the odd nature of our business we can assume it makes gross sales exactly equal to its assets, which means it sells $100 million gross. We'll give it a healthy 10% profit margin, which gives it $10 million net profits. Unrealistically, we'll assume it pays 25% taxes on the profit, or $2.5 million in taxes, leaving $7.5 million to divide between saving for future operations and passing to the shareholders. Future operations is increase the business - for our model, it's overcoming the effects of depreciation so we stay at that magic 100 million. There's the background, now for the exercise.

We reduce the tax burden by 1%. This time they pay 24%, and keep $7.6 million. At bottom there are two extremes with the probable result being a compromise. Let's examine the effects of the extremes.

Extreme 1 - add it to "future operations". Since previously we just barely balanced, this means we increase our assets to $100,100,000. Our annual gross (due to the rules) goes up the same, and our profit margin goes up the same proportion. Thus the subsequent year after we sacrificed $100,000 of tax revenue we collect 24% of $10,010,000 or $2,402,400. Which is STILL LESS than the $2.5 million we were previously receiving. In other words, not only does our production not gain enough to overwhelm the initial loss, it keeps losing. Our slight increase has to significantly increase our gross (and net) income for it to have the claimed effect.

Extreme 2 - give it to our shareholders. Congratulations, we recover 15% of the $100,000 we gave up. And the money goes into other corporations' assets (investments) in the best case, or gets spent on various stuff in the worst case. If the latter, we get (depending on sales taxes) up to 10% of the remaining $85,000 that year, and the rest becomes part of the regular gross profits of other companies - a slight surge, which is either unsustainable or (at best) a repeat of extreme 1 but for a different company and with worse increases. If the former, skip the sales taxes and the rest is the same.

It takes some different assumptions for cuts in taxes to net increase tax revenues. The core is the one mentioned in the previous post: You must be to the right of the Laffer peak, at such point where the dollars not taken for taxes increase net revenues so much that there is a positive gain overall.

By the way, let me dismiss a parallel argument while I'm at it. It goes something like, "if the tax burden is too high people aren't willing to put in extra effort for no more than they get out of it." The statement is true. The use of the argument, however, is to allege that the present burden is already too high. In real-world terms, however, this isn't so for us at this time. The defense is simple: are workers unwilling to accept overtime as the net pay increase is too marginal? For the first 8 hours or so for most workers the answer is "nope, gimme my overtime." Equally valid argument: are stores unwilling to increase sales as the tax increase cuts too much? Again, let us laugh.

Theoretically the rate can get too high. It's been so in some nations - when it exceeded 90% income tax rate in the UK for some people is an example. The US isn't at or near that point.


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