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SEIFFE:  Taxes -- Yet Again

Tuesday, December 20, 2005

By Ralf Seiffe

There can be no sensible person left on our political environment that does not understand the empirical effect of lowering taxes.  Two generations of experience have taught us that whenever taxes on income are lowered, the economy responds by producing more income.  As abundant and simple as the evidence is, there are both Republicans and Democrat senators who refuse to accept these facts.  These economic Neanderthals are prohibiting the Senate from concurring with the House’s extension of the current successful tax cuts.  Their opposition to these common-sense actions really tells us they oppose higher American living standards.  

One of the most important effects of tax cuts is that when they take effect, the economy expands at a faster rate than it otherwise would have.  Growth takes the form of new businesses making products or providing services that begin to contribute to the commonweal.  Additional economic activity employs people, generates new technology and, eventually, pays dividends or creates capital gains for the people who set up those new businesses.    

An important thing to notice is the order in which these things happen.  Every new business requires is an idea but ideas aren’t worth much without the necessary capital backing them.  A new business’ first task is to sell its vision to initial investors.  To complete that sale, the entrepreneur must not only find investors with enough money stashed away somewhere but ones who are willing to take on the risk his proposition entails.  

Investors with the capability to take a risk and make an investment are bombarded by entrepreneurs with “good ideas”.  This continuous flow of opportunity means that investors are already invested in projects they saw last month, last year or last decade. This also makes an efficient market so the returns available tend to clump in a range that will motivate new investments.  Proposals that do not meet these market return requirements aren’t successful in making that first sale to investors.   

When a new investment comes along, these investors must liquidate positions in earlier investment to fund the new one.  This only happens when the predictions for a new venture exceeds the reality of the existing projects.  To estimate this, investors make a number of judgments when deciding to liquidate a current investment and take on a new one.  These include the skill and experience of the management; the likely market for the product or service the new enterprise will make; the clarity and maturity of the business model; the time it will take to realize the business plan and the cost to put it all together.   

When calculating the cost of making a new investment, owners must make an estimate of the opportunity one gives up selling the existing investment; the liquidity of the market for the old company; and, of course the transaction cost the government imposes.  The capital gains tax adds to the cost of new investments in the sense that it must be paid when an old investment is liquidated to fund a new one.  So, to raise enough cash to fund a new project, enough old investments must be sold to generate the cash and pay the taxes the sale generates.  

It’s evident that the higher the transaction tax, the more expensive the new investment becomes.  For example, consider an investor faced with the opportunity to fund the new Whiz-Bang Widget Foundry.  He finds the Whiz-Bang project to his liking and calls his broker and asks how many shares of SmartMed that he already owns must be sold to raise the money to make the Whiz-Bang investment.  In a no capital gains tax environment, the broker responds that selling 6,000 shares at the current market price will do it.   

Except for the fact that he met the promoters of Whiz-Bang, the investor is happy with the prospects for SmartMed shares he owns.  But, after he’s done all his due diligence, he finds that he’ll do 20% better by selling SmartMed and redeploying those funds into Whiz-Bang.  It’s a deal that gets done and in the next year, the Whiz-Bang folks open a factory, hire some workers and begin marketing their product.  The workers pay income and Social Security taxes; the business pays sales taxes and, if profitable, it pays dividends.  

That’s all good, but what happens to SmartMed?   Nothing, actually. The investor’s sale of his SmartMed shares may depress their price, but SmartMed continues to make whatever they did before.  No one gets laid-off, the salesmen still sell, and customers still enjoy the SmartMed line.   

Now consider the same situation with regular taxes in place.  The call to the broker is somewhat different; the same 6,000 shares of SmartMed need to be sold to fund the WhizBang project but another 4,000 must also be sold to pay the income taxes.  This means the investor must sell a total of 10,000 shares to make the Whiz-Bang investment.  Taxes effectively raise the price of the Whiz-Bang investment, in terms of SmartMed shares, a whopping 66%.  Since the investor’s risk-adjusted estimate of Whiz-Bang’s prospects is only 20% better than staying in the SmartMed shares, this is a deal that will not get done.  

Who are the winners and losers in these two scenarios?  In the first case, it looks like everybody wins.  The old company stays in business; the company and the workers keep working, they still make money and still pay taxes.  In addition, the investor and the entrepreneur have created a new company that provides new employment, new taxes and new technology.  From the government’s point of view, there are now two new tax sources, rather than one. This is the ratchet and cardinal reason that low taxes are good for investors, workers and the government.  

Now, let’s look at the second scenario but this time, let’s substitute the word investor with words “rich investor”.   In this scenario, the rich investor is busy enjoying his investment in SmartMed when the poor entrepreneur approaches with his plan.  Because the price is 10,000 shares, not 6,000 shares, the new investment’s speculative returns are not high enough for the rich investor to part with his SmartMed investment.  The rich investor rejects the plan and sends the entrepreneur on his way.  No new business, no new workers and no new technology.  The losers are the workers that weren’t hired, the technology that didn’t get developed and the taxes that won’t get paid.  The fact is the only winner is the rich investor.  True, he loses the opportunity of the new investment but because the taxes raise the price of any investment, he’s really not interested in taking on that new project.   

The same process occurs when large businesses decide where to invest their capital.  Like the small investor, it will go where the returns are highest and taxes so distort returns that they are often the deciding factor.  The rest of the world is discovering this and going to low-cost tax systems in terms of compliance and rates.  Exhibit A is Ireland ; it’s reduced the government’s share of the economy and, as a result, it’s enjoying a net inflow of population for the first time since the Potato Famine.  Opportunities are better there because American, German and other national companies are establishing branches there and employing Irishmen.   

Raising taxes, especially on capital, has been a pillar of the left’s agenda since Karl Marx set out his principles more than 150 years ago.  His spiritual heirs, the modern class warriors that populate the Democrat Party and their fellow-travelers in the Northeast version of the Republican Party continue to espouse that socialist inaccuracy.  They repeat the mantra “end tax cuts for the rich” by which the really mean “raise rates and send more money to us”.  The incontrovertible evidence that low taxes improve the lives of their constituents and creates more tax revenues for them shows they must be motivated by something other than logic.  Not only are they economically wrong, they are putting their prerogatives in front of their constituents.  

If these selfish senators succeed in derailing the tax cut extensions with their self-interested vision of higher taxes, they will not inconvenience the rich.  Rather, the will make victims of the very workers they want to help and the government they pretend to lead.    

© 2005 Ralf Seiffe

Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader and Illinois Review.