Planning for Life

Taxes and Cognitive Dissonance

Posted by Harry S. Margolis on January 6, 2013

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By Harry S. Margolis

I try not to get too political in these blog posts, but one recurring theme in the debate over the fiscal cliff and taxes has long left me boggled.

One of the arguments against raising tax rates has been that it will discourage investment and entrepreneurship by small business owners. Sen. Orrin Hatch said this in a press statement he released last month. He cites an Ernst & Young report that concludes that:

Through lower after-tax rewards to work, the higher tax rates on wages reduce work effort and labor force participation. The higher tax rates on capital gains and dividend increase the cost of equity capital, which discourages savings and reduces investment. Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.

In other words, since if we raise taxes business owners will bring home after taxes a bit less of what they earn, they'll have less incentive to work and create jobs. Since investors will take home after taxes on their capital gains and dividends a bit less if the Bush-era tax cuts expire, they'll be less inclined to invest and take risks.

This makes some sense if the proposed tax rates were to increase to prohibitively high rates, but it stretches credibility that increasing the top marginal rate less than 5% from 35% to 39.6% -- as was finally agreed -- will discourage investment or entrepreneurship. If the proposal was to raise the marginal tax rate to 90%, which it once was, then I can see that it would discourage work and risk taking.  Why would you work harder or invest more if your you will only take home 10 cents on the dollar? But will it really make any difference to the choices employers make if they will take home 60 cents on the dollar rather than 65 cents?

It could even be argued that it will make higher earners work harder or employ more people to make up that five-cent shortfall. In addition, a higher tax rate might spur investment by business owners since a dollar invested is not taxed.  A business owner may choose to reinvest earnings building the value of the business rather than taking income that will be taxed. This is especially true given that the tax rate on capital gains is significantly lower than that on income, meaning that if the business is ultimately sold at a higher price due to such reinvestment, the business owner will receive the same funds at a lower tax cost.

In terms of investors, people with money have to put it somewhere, whether that's in banks, bonds, stocks, venture capital funds, or under the mattress. Taxing returns differently depending on the type of investment will certainly influence where people put their money, but again it's hard to believe that raising rates across the board will have much impact.

Employers will hire more employees and investors will invest when they expect to make money by doing so. They won't if they don't expect a good return no matter the tax rate. Businesses need to have confidence in the economy, necessary infrastructure, law enforcement to make sure that they are operating on an even playing field, and customers. Many of the factors require a strong and stable government with consistent funding.

As a small business owner, I will spend money on employees or other investments if I expect doing so will build the business and help us make money in the short or long run. That is my goal no matter the marginal tax rate.

Topics: income taxes

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