Taxes and profitability: Will increasing tax rate destroy jobs?

Gross profits

Sales Revenue Labor cost, cost of raw material

Operating income

Income before taxes

Net income

Marketing new product development

Interest on its debt

Income tax

Figure 1. Inflow and outflow of funds from a firm. The claim that increase in tax rate for those in higher income bracket will kill employment was repeated any number of times during the election campaign and continues to made even now. As recently as December 12th, Speaker Boehner said: Were fighting against increases in tax rates that destroy jobs.1 There is no doubt that if the taxes are high enough think of close to 100 per cent tax on profits - firms will not only not increase employment but will close down. Yet there are periods in the United States history, most recently during the Clinton presidency, when the taxes were much higher than now and so were the levels of employment. An examination of the operations of the firm will provide clarity to the effect of taxes. For simplicity, Figure 1 examines the financial flows of a proprietary firm that is in an equilibrium (producing a fixed output).2 The sales of its products, whether goods or services, generates an inflow of funds represented by the size of the box Sales revenue. The owner cannot take it as his income as he (she) has legal obligation to make certain payments. He has hired labor to work and purchased raw materials to be used in the process of production. The payments for the cost of production, is represented as a leak through the pipe pointing downwards; what is left the gross profits. Seldom does a product sell itself. The firm has to maintain a sales force to contact retailers and customers and it has to advertise. What is left after incurring the cost of generating sales is operating income. The firm has to have a plant for its production. To finance the cost of constructing the plant and for financing inventory of raw materials, it borrows by issuing bonds or by taking loans from financial institutions. The interest on the loans is another cost for the firm. Since all these expenses are costs incurred in the process of production, the government permits them to be deducted from sales revenue before determining the tax liability. The proprietor in making decisions examines their effects on his net income. This discussion shows clearly that income tax is just one of the outflows from sales revenue. In this static framework, an increase in taxes will reduce net income. Does that mean that the firm will reduce employment and its output? Now consider how economy affects the firm. If there is increased demand for its product, the firm will consider increasing output. If it plans to do so, it will have to buy more inputs and hire

additional labor. Higher output increases sales revenue but will add to its wages and the cost of raw material. The firms will increase output only the increase in revenue exceeds that of its costs. If the increased sales are from an economic upturn, two other changes can occur. Firm can increase its price at which it sells its product and this contributes to increased sales revenue. At the same time wage rate will be going up and it inflates costs. The firm will not cut output just because wage rate increased. It is the effect on net income that is decisive. While for an individual firm, increase in sales revenue and cost increases are independent changes, for the economy as a whole they are inter-related. Increase in wage payments through increase in employment and wages, adds income to the households in the economy. The households will then spend more, increasing demand for products of most firms. If taxes increase in itself will reduce the net income. If the tax increase is occurring when economy is recovering, the increased sales revenue will result in higher net income for the firm and encourage it to expand its output. The parallel between the effect of an increase in wage rate and that of tax rate on the decisions of the firm is striking. If the government increases its expenditure, it is creating demand for products of the private sector and adding to the income of households who will then buy more products. A cut in expenses will reduce demand and employment. Sequestration will be a disaster as it will be a drag on the economy by both increasing taxes and reducing government expenditure. That is the reason I argued that, in spite of all the noise, Congress will not dare to go with it.3. The nonpartisan Congressional Budget Office has, in their report, considered in detail the effect of various proposals to avoid the Cliff. Economic Effects of Policies Contribution to Fiscal Tightening in 2013 deserves careful reading.4. Footnote: 1. http://www.politico.com/story/2012/11/84364_Page2.html#ixzz2F5LVQzus
2.

The structure of a corporation with shareholders and professional managers adds complications that do not alter the argument in this article. Assumption of constant output will be relaxed shortly. For a discussion of the operations of a firm, see Opportunities and Choices, pp. 84-90. http://www.scribd.com/doc/49513234/Opportunities-and-Choices.
3.

http://www.scribd.com/doc/115340400/Who-is-Afraid-of-Fiscal-Cliff

. http://www.cbo.gov/sites/default/files/cbofiles/attachments/11-08-12-FiscalTightening.pdf

Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2012 Rama V. Ramachandran