Standing in buckets

Government taxes mean that individuals and corporations only keep a certain portion of their gains whilst at the same time they realize 100% of their losses. As Hazlitt put it in Economics in One Lesson:

“When a corporation loses 100 cents of every dollar it loses, and is permitted to keep only 60 cents of every dollar it gains, and when it cannot offset its years of losses against its years of gains,  or cannot do so adequately, its policies are affected.”

This is a particularly pertinent point at present, since many corporations are starting to make some serious losses following a series of years in which they made bumper profits. If we were to regard the activity of these corporations over their entire lifetime then, on the balance of things, many of these corporations might actually be running at a profit, if we were to take taxes out of the equation… so they are still, even in the wake of their most recent losses, net contributors to the overall economy and perhaps were it not for taxes their shareholders would choose to continue operations. For practical reasons, however, taxes are levied annually and because these companies are unable to offset their current losses against earlier profits (which they have already paid taxes on) they are declared to be unprofitable and in many cases are driven into bankruptcy…

For example, Widgets Inc. starts up business and makes $100 in their first year of operation… on which they have to pay taxes of $40. They now have $60. In their second year of operation they make a loss of $70 and thus, unless they are able to find funding, they are technically under the water. Despite having made an effective profit of $30 over the course of the two years that they have been running, the tax burden that they have to shoulder has forced them out of business.

I guess this culls off the least profitable of the profitable companies, however Hazlitt’s point can hardly be denied – Taxes Discourage Production. Essentially a nation that imposes a 40% income tax is setting a bar over which all companies must jump if they are to stay afloat. For although some years they will make losses and others they will make profits, they will not be able to adequately offset their profits against their losses (particularly in times like these) and so over the long term companies must not merely break even but they must make a certain minimum amount of profit simply in order to stay afloat, and the magnitude of that profit is necessarily dependent upon the proportion of their revenues that are spent on taxes.

We could state the above somewhat more mathematically by saying that in order for a company to remain profitable, their EBIT (Earnings Before Interest and Taxes) must be greater than both the Interest that they pay on loans and the taxes that they pay during any profitable years of operation.

EBIT > Interest + Taxes

At this point you can perhaps start to see the enormous contradiction inherent within present government policy. For at the same time as the imposing income taxes governments around the world have also established the vast apparatus of central banking that has been assigned the task of controlling interest rates. In the United States this organization (The Federal Reserve) has two mandates: that of “stimulating growth” and that of “controlling inflation”.

Setting aside their deplorable track record with regards to controlling inflation, let us focus for a moment on their other role of stimulating growth. Despite price fixing having shown itself to fail time and time again, the manner in which the central bank purports to “stimulate growth” is by artificially lowering nominal interest rates so as to tip the equation above in favor of businesses. For if one of the main costs that businesses incur is interest then why don’t we simply write laws to lower interest rates (or even better, come up with a fantastically complex system to achieve the same thing indirectly, with vastly more effort and at a vastly greater cost)? The rather warped view of those supporting the central bank is that if they can keep nominal interest rates down then entrepreneurs, with the prospect of cheaper capital, will be more inclined to start businesses.

Ignoring the numerous difficulties that the central bank must face in order to actually make capital cheaper (rather than just cause a shortage, as is what we would expect in any industry where price caps were imposed) the central bank’s attempts to make capital cheaper are in direct conflict with the policy of taxation. For as we have already described, the bar that companies must jump over is not that of interest rates but that of interest rates + taxes.

It is therefore ironic that the government should be trying to tax itself out of the current mess. For in increasing government spending the government is implicitly and unavoidably raising taxes. All government revenue, without exception, comes from taxes and so there is no way that government can increase its expenses without implicitly increasing taxes. The irony is that both the bumper profits of recent years and the sudden crisis resulting from this, in which a disproportionate number of companies all go bust at the same time, placing us squarely in the midst of a recession and falling government revenues, are a direct result of government sponsored policy to artificially lower interest rates (supposedly to lower the costs  to business and stimulate growth).

And so recent moves to raise taxes in California and guarantees of future taxation implicit in Obama’s promises to increase government expenditure are both very much a direct result of the insane efforts of government to “stimulate growth”. Like children in a bath tub they have seen the rubber ducky of Interest rates bobbing towards them and, in an effort to make it disappear through force of will, they have tried to push it under the water. Unwittingly, the very force of their hand serves to raise the overall water level of taxation and other expenditure upon which the rubber ducky floated and so now a whole bunch of other kids in the bath tub (who weren’t tall enough) are now in the process of drowning. OK, I’m maybe straining an analogy there a little bit but, quite simply, the Federal Reserve trying to push down interest rates in order to lower the bar that businesses have to jump over has resulted in their pushing up (by vastly more) taxation and has thus raised the bar that not only businesses but all of the hapless victims that participate in their monetary system must jump over just to survive.

What is the current wave of taxation to be used for? Almost without exception, attempts to prop up the various collapsing walls of the very low interest rate policy that got us where we are today: to bail out failed banks, to bail out mortgage lenders and insurers or perhaps even to bail out the borrowers themselves… or sometimes to bail out companies that would have been profitable neither with nor without taxes (such as the auto makers).


Efforts by government to “reduce the costs” to businesses by lowering nominal interest rates merely increase the costs to business by at least that degree to which government participates.

In order for businesses to survive, as a rough guide to sustainability, they must ensure EBIT > Interest + Taxes. Any attempt by government to decrease the Interest component of the equation necessarily increases the Taxes component by at least as much (and almost doubtless by more, since the bureacrats and bankers effecting this transformation of Interest into Taxes must be paid).

At times like these, I cannot help but be reminded of one of Churchill’s better quotes:

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle” – Winston Churchill

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