I'm Ben Gruber

2013 / 28 May

Economics: Alternative Income Tax Theory


joecrabshack

 

I am not an economist and am certainly not “down” with the “util,” but I do enjoy thinking about general and more nuanced macro economic principles. Among the many principles, I find the effects of changing marginal income tax rates particularly interesting to think through. Since I have ran a small business for the last 6 years and am currently the owner of one, I tend to think of the effects of the tax rate change on this particular group most often. Recently while going through the different individual incentives and how they effect the economy at large, I think I have stumbled upon an interesting spin on a classic concept. After looking around for hours, I could not find a single mention of it, so I thought it was worth writing up. Let’s jump into it.

First off, why would marginal income rates effect businesses behavior? Well, many small businesses incorporate as an LLC or similar instruments which simply shield them from liability while allowing them to report their businesses profits as part of their personal income. There are also other reasons, but for now this what we will concentrate on. Let’s get into the classic thinking.

 

The Usual

From my understanding, the basic economic logic states that if you raise tax rates, businesses on the margin will engage in less new (potentially lucrative) business building initiatives. This would result in a slowing of the economy because there would be less investment into business expansion which means less jobs and less business for the businesses that would be used in the investment.

The main reasoning in why businesses as a whole would engage in marginally less investments is because the risk for the investments stays the same at any tax rate but the potential upside of the investment change as tax rates change (they shrink as taxes go up). And since different entrepreneurs have different risk thresholds, a certain percentage of them would no longer engage in an investment that they would have otherwise engaged in if the tax rate was lower (and payouts were higher). It is easier to think about this with an example.

Joe Crabshack owns a seafood restaurant on the beach. His crab boils are delicious and he does pretty good business, but thinks he can do even more if he builds a back deck over looking the water. It will cost him $10,000 all in to make the deck a reality (this includes labor, materials and everything else). He does some analysis and figures that he can make $20,000 from the investment. This would mean that he would make profits of $10,000 (giving the investment a real “gain to risk” ratio of 1 to 1)*. If the tax rate at the time of the invest is 30%, he would stand to make $7,000 on his $10,000 investment (7/10 – gain/risk). If the tax rate is 50%, he would take home $5,000 (5/10 – gain/risk). How does this effect Joe’s decision whether or not to invest in the deck?

Joe is an eternal optimist that loves risk but his wife is more logical and conservative and so the business’ “gain to risk” ratio for investments is 6/10 at the most. For every $10 dollars they put in, they need to reasonably assume they can take in $6 of profits after taxes or else they will not take the risk on that investment. Because their analysis says the back deck is only a 5/10 gain to risk ratio when taxes are 50%, they will not go ahead with the investment and the back deck will not be built. On the other hand. If the tax rate is 30%, the gain to risk ratio is 7/10, which is better than their minimum risk threshold, so they will build the back deck. So raising the tax rate from 30% to 50% in this case will change whether or not Joe invests in the deck.

This is then extrapolated to say that if investments marginally slow across the whole business sector due to higher tax rates than the economy will slow down.

 

My Take

I personally I am not sure I even agree with this basic idea. I think it ignores some pretty basic realities, such as how the gained money from the increased rate on those that do invest (and succeed) gets reinvested, how small businesses analyze potential profits in the real world, and maybe most importantly it assumes a static set of investment possibilities (i.e. Joe could potentially come up with an alternative investment idea, for example to build a floating boat deck in the water rather than the classic deck, if the classic deck was over his risk threshold). But, for the purposes of this post and my new theory, I am going to agree with the basic notion, assume it is the reality and take it another direction.

My new take is actually extremely simple. And it concentrates on a particular undiscussed built in assumption in the classic theory. The theory automatically assumes that is always BETTER (for the economy) for more investments to be made. Remember, we are assuming that marginally more investments will be made the lower the tax rate goes. We however do not necessarily need to assume that each one of the investments will turn out positively.

Empirical evidence would need to be used to prove this, but I am arguing that one can logically see it possible that there is a point where marginal tax rates are low enough that the government is actually incentivizing investment ideas that are highly likely to fail.

Remember from above, whether the investment succeeds or not is independent of the tax. It is only whether or not the business decides to take on the investment that is effected by the tax rate. It is then totally conceivable that investments with a certain gain to risk ratio, lets say 1/1 (this is a made up ratio to illustrate the point) have an actual success rate of something extremely low (say 1%) and when they do succeed, they only result in modest profits. Maybe a higher tax rate is a disincentive for bad investments. Again let’s use the example from above.

Remember, no matter what the tax rate the actual success rate remains constant. Let’s now say that the tax rate is 30%, which made the gain to risk ratio 7/10 and Joe made the investment. He got a beautiful deck. However, it turns out it is just too darn hot outside and no one wants to eat when it is that hot. So Joe loses the money on his investment and ends up not being able to invest the $10,000 on a new brick oven when his breaks. On the other hand. If the tax rate was 50%, his gain to risk ratio would be 5/10 and he would not have invested. He would then have saved the $10,000 and would still have the dry powder for a better idea when it came along. This would be a net positive for the economy.

Here is my basic thinking as to why this is true. Not all investments are the same. Certain investments on average are better than others – I think we can all agree on that. So keep that in mind as we talk through this next part.

Because of the very nature of the classic principal, each percentage point that the tax rate gets lowered, another percentage of investments are made that otherwise would not have been – but each one of those investments are a certain percentage riskier than the investments** that were made before the rate decreased (or else they would have been invested in even with the higher tax rate). We can assume that a riskier investment in this case means that on average it is a worse investment, so each time the rate goes down a percentage point we get worse and worse (read: less value) ‘things’ being built. I then could see there being point where we have lowered the tax rate low enough that people are making investments (producing things) that should never have been made (i.e. ice makers for igloos). At this point the line flips and each new investment made is WORSE for the economy than if it was not made.

 

Conclusion

I think that in theory this shows that having more investments is not necessarily BETTER for the economy. And because more investments are not necessarily better for an economy, any basic principle that demonstrates simply MORE investments – indiscriminate of type – is not proof that it is a BETTER strategy for the economy. So we can at the very least, cast doubt on whether lowering rates on taxes is always BETTER for the economy.

Personally, when all is said and done, I am not sure I even believe my own theory to be true. As I mentioned earlier, I based it off a concept that I did not believe in in the first place. Basically, this train of thought was intended to prove yet another reason why that theory did not hold up and so we could move away from that being common knowledge. Anyway, I guess my theory actually could be a possibility and will continue to look to see if I can find any data that might help either support or disprove it. I think both is possible once you move outside of the theoretical realm.

*I have invented the “gain to risk ratio” here in order to illustrate a simplistic model as to how a business person might form their risk portfolio.

**I mentioned that each new investment at a lower tax rate would be more risky. That is true, but I ignored that there would be more total investments than at the higher rate. This again comes to an empirical measure to determine whether or not having more risky investments (how risky and how many more) are a net gain or not to the economy and does not change the underlying theory.

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