Taxes and Small and Middle-market Businesses

It’s obvious:  “Cutting taxes to Small and Middle-market Businesses would create jobs.”

As usual, one man’s obvious principle (frequently accepted as “fact” or “natural law”) is another man’s dubious (frequently regarded as “fiction” or “myth”).  In the real world, this claim complicated.  First, though, we need to eliminate the naïve view, viz., if you reduce the tax payments required of a small company, its owner would hire employees with annual total compensation equal to the value of the reduction in tax payments.  This idea is ridiculous.  Expanding his payroll is the last item on the small business owner’s agenda; he will add employees only if demand for his product or service exceeds capacity by enough to force him to work harder than he wants to, or do jobs he doesn’t want to do, and if he is confident that demand will continue to grow or stabilize at this new, higher amount for the foreseeable future.

The initial, short-term, effect of reducing marginal tax rates to businesses is to enrich their owners.  In addition, there is no competitive advantage from tax rate reductions to a particular company in a domestic market.  Rate changes (up or down) affect all companies equally.  As a result, competition would drive prices toward a lower equilibrium price (where marginal price equals marginal cost) at the same output.  Short-term result:  enrich owners; long-term result: reduce prices and, thereby, enrich costumers.  Advocates of tax rate reductions to businesses regard this long-term outcome as the way to create jobs.  They believe that by reducing the price of a good, producers create demand for it.  This growth in demand persuades producers to increase output.  To increase output, they must hire more people to produce the additional goods.

This belief is simplistic.  There are three sources of complications that render this view inaccurate, if not simply false.  First, companies may have unused capacity.  Second, the price/output point of supply-demand equilibrium has moved down the demand curve, in which case the total value of output remains constant, rather than having shifted the demand curve to the right.  Third, the remaining owner-competitors reap a windfall from exogenous events. 

In the first case, owners would hire no new workers nor would they start or accelerate their planned investments in plant or equipment.  In a recession or slow-growth rebound, many companies have plenty of unused capacity. Until that capacity is utilized fully or producers are confident that it will be used in the foreseeable future, they won’t expand.

In the second case, competitors just have to work harder (produce more units) to maintain their share of total industry output or the market for their goods.  As prices decline, competition intensifies and less-profitable and unprofitable producers leave the market.  They leave the market by eliminating those product lines or selling them.  If they eliminate them, all of the jobs disappear.  If they sell them, many of the production, warehouse, logistics and finance and administrative jobs would be consolidated into the buyer’s operations.  In both scenarios, jobs are lost, and plants, warehouses or offices would close and remain empty for some time.  Local economies and landscapes would be damaged or devastated (think steel and the Monongahela River Valley, although the competitors were international).  People would suffer (and have suffered) serious economic hardship from such dislocation.

In the third case, owners don’t invest or spend this money immediately; they pay themselves more than they would at initial marginal tax bracket, and they save this additional pay.  Buying outstanding issues of stocks, bonds or options on the securities exchanges is not a form of investment; it is a form of saving.  No new assets or value are created by these purchases.  If they lack confidence in the economy, they move some of it out of the economy completely by converting it to precious minerals, to other currencies or to real property (commodities, art, real estate, etc.) unrelated to their company’s business activities.  Of the remainder, they keep some in cash (to increase liquidity as safety precaution or to compete for investment opportunities) or buy bonds (lend money to private companies or governments).  If they are confident that the economy will rebound in the short term, they keep some in cash, invest some in the equity markets, and invest some in their companies.

Proponents of tax rate reductions for businesses always argue that there is no economic difference between different methods of stimulating business activity.  In the very long term, this claim seems reasonable.  But, the mechanism by which such stimulus works is complicated and depends too much on the long-term expectations of people and institutions.  These expectations are subject to significant fluctuations in an array of political and economic forces that are neither controllable nor predictable.  In the short term, this claim is ridiculous. 


1 Comment

Filed under Economics, Policy, Taxes

One response to “Taxes and Small and Middle-market Businesses

  1. So incredibly helpful!


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