Low Tax Rates Help Us All

One issue of contention this election year is the difference between the economic philosophy of the president and his future republican opponent. President Obama pretends our problems are solved by asking the rich to  “pay their fair share.” Republicans claim we may cut expenses and taxes and let the economy grow its way out of debt.  

We know Republicans know how to cut tax rates, but they do not show the ability to cut expenses. The purpose of this blog is to explain the effect of tax rates on investment.  

President Obama and others on the left say this is a gift to rich people. In fact; it is the best method to grow the economy for everyone.  

My goal is an understanding of the effect a tax rate has on an investment. I am not discussing every aspect of investment decisions, but rather just the role of taxes. Income tax is a cost of doing business. It has the same effect on profit as any other expense. A monthly expense of $1,000 for rent has the same effect on profit as $1,000 of taxes. In both cases the investor must earn more than $1,000 to pay the expense and to achieve the required rate of return.  

When politicians say they want increased taxes on investors they are saying they wish to eliminate an entire class of investment options from those whose tax rates are increased. The increased tax rate may collect more taxes on income but there also is a decrease in taxes collected from businesses not created or investments not made. The congressional budget counters count the potential increase in taxes but not the potential loss of revenue from less investment. This creates a bias for more taxation rather than economic growth to increase tax collections.

There is another way to look at the concept discussed above. Assume the government passes a law that says every dollar earned greater than $100,000 is taxed at a 100 percent tax rate. This means a worker will see no income for work that increases their income above $100,000.  

Here is how it will work. Once you earn $100,000 every extra dollar earned would is taxed. In the real world you would stop working after you earned $100,000. Why would you go to work if your net pay was zero. Assume a person made $110,000 the year before the new tax law is passed. Congressional budget counters see $10,000 more in taxes. This is because the new rate will collect the $10,000 above $100,000. In reality, they will collect very little money as most people will stop working after $100,000 is earned. This kind of analysis ignores changes in behavior due to tax increases and is flawed.

Tax rates effect behavior. Any economic policy that does not take this into consideration is doomed to failure or if successful is due to luck. Consider an investor who requires a 10 percent net return for any investment made. This investor requires a real return greater than 10 percent before the investment is considered. This is because the investor must pay taxes and earn 10 percent after he pays taxes.   

Chart 1 shows the effect different tax rates have on the required rate of return. When there are no taxes the investor considers every investment projected to return 10 percent or more. This is because there are no tax expenses.  

When the tax rate is 50 percent, the investor will look at investments that earn 20 percent or more.  This allows the investor to pay the 50 percent income tax and still earn 10 percent.

Increased income tax rates make it harder for new business ventures to receive funding. Those opposing increased marginal rates see the businesses not formed while those who favor increased tax rates do not see the unformed business as the expense it is.  

Chart 2 is one example of the effect of a change in tax rates has on investment. A 35 percent tax rate requires an investment to make 15.4 percent to net 10 percent after taxes. This means all investments that achieve a 15.4 percent return or greater are considered by this investor. A tax rate of 45 percent increases the required investment return to 18.2 percent up by almost 3 percent. This increase in tax rate eliminates all investments earning between 15.4 percent to 18.2 percent from consideration. This means less investment and fewer jobs.

It is not enough to claim anyone who does not support increased taxes is for the rich favors the rich. The power of lower tax rates is it gives an entire class of investors the option of investing in start up companies that would not occur with higher tax rates.  

We live in the real world, not a cartoon world where tax rates and markets do not matter.  We cannot tax our way to higher revenues and prosperity. This is only achieved through the combination of sweat and dreams of human beings and free markets that allow the best to succeed.