In his Dec. 9 column, Dave Danforth posits an interesting economic theory: that people don’t consider profit potential when deciding whether to expand business activity. He bases this conclusion on the hypothesis that, even though they reduce the net profit from a business, taxes aren’t like other business expenses.
Every day, every person decides how to spend his limited time, money and other resources. Virtually every economist would agree that people spend their resources on endeavors they believe will increase their well-being the most. A simple example illustrates. Suppose Mr. Danforth has a newspaper in each of two states. Suppose he has $10,000 to invest in new computers to improve productivity and increase profits by $5,000 a year. One of the newspapers is in a zero tax state and the other has a 10 percent tax rate.
Mr. Danforth would increase his financial well-being $500 more a year by investing in the zero tax newspaper rather than in the 10 percent tax newspaper because he would avoid that much tax by doing so. He wouldn’t be much of an entrepreneur if he didn’t consider the tax element in deciding where to invest his $10,000. That is why low tax states generally have faster economic growth than high tax states.
Mr. Danforth opined that a business would not change its hiring levels because of tax rates. In an expanding economy, there is more hiring, along with more use of other resources. So the question is whether tax burdens affect the rate of economic expansion or contraction.
If businesses had to pay a 90 percent tax, that $10,000 of new computers probably wouldn’t be invested in any newspaper or other business anywhere because there wouldn’t be enough after-tax profit opportunity. Sure, the business owner would seek to increase his well-being. But at confiscatory tax rates, he might increase his well-being more by investing in untaxed municipal bonds, or by engaging in untaxed non-business activities from which he derives non-pecuniary well-being. He might spend more time fishing, tinkering with his car, lobbying for a tax reduction, or writing silly letters to that newspaper. He would substitute untaxed non-financial rewards for the diminished financial rewards left after paying high taxes.
A tax increase doesn’t have to be confiscatory to have this effect. If a business can make an additional $700 after tax by earning another $1,000 pre-tax, the owner might decide it is worth the effort and risk and go for it. But if taxes are raised and the owner could earn only $600 after tax for the same effort and risk, some (not all) owners would decide it isn’t worth it; they would spend the extra effort rebuilding that Mustang instead.
The point is not that a relatively small increase in taxes will prevent all additional economic expansion. The point is that it will prevent some additional expansion by incenting some businesses to take their feet off the accelerator. The more taxes increase, the lighter the touch on the accelerator. If you don’t believe it, ask yourself: Can you imagine anyone saying, “I think I’ll hire some people and expand my business because my taxes just went up”?