The Real Effect of Taxes on the “Rich”

A very real post from a real banker (not a Wall Street bank) who serves very real clients including many business owners that have very real and very hard choices  to make every day…………

The idea that you can raise taxes on the rich without hurting the employees that work for them is the product of a simple-minded theory-based group of people that in my experience and with few exceptions have never owned a business and never had to make payroll.  This is how a real business owner thinks with regard to hiring:  “If we’re making a profit we’ll try to hire another person to extend that profit further and we’ll keep hiring until it doesn’t make sense from a profitability standpoint to hire any longer.”  As with many of my examples, that is a bit of an oversimplification and there are certainly exceptions but think about it for a minute and you’ll realize how true it is.

On the other hand, if they are not making a profit they’ll start cutting expenses until they have an economically viable model.  For almost every one of my clients, payroll is the biggest expense which means layoffs are almost always a consideration when expenses need to be cut.  I hope everyone can agree on at least this much.

Here is a fictional example to show how it works in more detail — Take a small business that employs 10 people and for the purpose of the example assume they all do the same thing at this business.  Obviously this is not realistic since responsibilities are spread among sales, administration, finance, etc. but just suspend that knowledge for this simplified example.

Every business owner or team/division manager knows the value each of their employees brings to the company.  In the case of our fictional, simplified company, employee #1 brings the most value and employees #9 and #10 bring the least.  Value may be defined in terms of revenue enhancement or expense reduction but there really is no other way for an employee to bring value in an economic sense.

Before I get to the tax issue, I’ll touch briefly on why those who employ others are justified in expecting to make more than their employees.  It really boils down very simply to risk & reward.  Business owners take risks every day in many forms including taking on personal responsibility for company debt, the personal liability (primarily civil) that comes with running a company, and the fact that they are typically “all in” with the business.  An employee can often simply change jobs (obviously more difficult in a tight labor market) if they don’t like their current role but a business owner doesn’t have the same luxury.  They invest years of their lives in making an enterprise work and if it is not working out for them they can’t just switch to a new company without nearly certain economic loss.  All of that to say that those that take the risk can reasonably expect more of the reward (how much more is up to each individual to decide).

Back to the tax issue……….assume for this discussion that the employer in our fictional example decides that a fair amount to expect in after-tax profit for taking on the risks and hard work is $300,000.  Otherwise, they will shut down the company, give up all of the risks & hard work, and get a job working for someone else even if for a lower amount.  It doesn’t matter if you or I or anyone else thinks this number is fair because this is a decision reserved solely for each individual business owner.

Assume the business owner is earning an after-tax profit of $300,000 which is her minimum requirement.  Now assume her business’ tax rate increases from the current 35% to 39.6% as will occur if the Bush tax cuts are allowed to expire.  Further assume that this will reduce her after-tax profit to $285,000, below her minimum requirement.  Her first move will not be shut the company down but to determine how to cut expenses.  Again, since payroll is typically the largest expense, employee #10 is at risk of receiving a pink slip.

If on top of higher taxes you add dramatically higher health insurance expenses or other factors that further strain profitability, then employee #9 will likely be laid off too.  The other 8 employees that remain, including the owner, will have to work harder to make up for the lost productivity.

This really is the way that real business owners who are facing real economic challenges think and make decisions.  You can argue whether or not any given level of profit is fair* or that employers shouldn’t fire employees but instead personally take a pay cut but in reality the example above is very common.  And in reality, there are tens of thousands of business owners that aren’t making a decision to cut their compensation from $300,000 to $285,000 but instead are running businesses that are making far less.  Many of these individuals are facing very difficult decisions and will have to lay off employees (irrespective of whether taxes increase or not).  Increased taxes will only damage these companies further.

Repeating a sentiment from my last post, this is not a political commentary but instead a simple issue of mathematics.  Like everything else in life, businesses are distributed along a bell curve of profitability.  Many employees of companies in the tail of the wrong end of that bell curve will (not “may” but “will”) lose their jobs if taxes on businesses increase.  The search for the elusive concept of fairness* will harm many of those it is most intended to benefit.

*Life is not fair.  It never has been and never will be.  This part probably belongs in a personal blog and not one for business but, in my opinion, over-emphasizing fairness can be a distraction from the more noble pursuit of simply doing the best possible every day with what we have been given.

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