Sunday, August 08, 2010

Higher taxes mean less production

Published in The Tennessean, Sunday, August 8, 2010

Higher taxes mean less production

by Richard J. Grant


When we want to discourage an activity, we might do so by raising the cost associated with doing it. Depending on the activity and the circumstances, that cost increase could take the form of a higher price, a tax increase, a fine, or a disparaging public-relations campaign.

This is the idea behind “sin taxes,” such as those often placed on tobacco and alcohol. The same deterrent is directed toward activities deemed to produce excessive pollution.

Governments use taxes primarily to raise revenue for their operations, not to discourage the activity that is taxed. But the discouragement comes with the imposition. The higher the tax rate, particularly the marginal tax rate, the greater is the disincentive to produce one more dollar of taxable income or profit.

Just as taxation reduces the value of undertaking the activities that are taxed, it also reduces the values of assets. An increase in property taxes will reduce the market value of your house below what it would have been. The total effect does depend on the value to you of the services that are provided from the tax revenues, and we would hope that the net effect is positive, but the tax effect leans against this. All else equal, the higher the property tax compared to other municipalities, the less a potential buyer is willing to pay for a property.

When we buy shares in a corporation, we expect to receive some combination of dividends and capital gains. If we suddenly learn that dividends and capital gains are subject to taxation, the price that we are willing to pay per share will be less than it would have been without the tax. The corporations “themselves” also pay taxes, including a significant corporate income tax. All these taxes reduce the values of corporations and businesses in general. We can only hope that the services the tax revenues pay for will bring a net benefit.

Costs can be increased also by government mandates and regulations. When a regulation is “effective,” that means that it causes us to do things differently than we would have. Even when it doesn’t change our operations significantly, the compliance documentation (paperwork) uses up resources and management attention. It is difficult to find government regulations and associated administrative processes that produce clear net benefits beyond the chain reaction of unintended consequences.

As the regulatory network grows, the net burden grows. As is the case with taxation, beyond a certain range of imposition, the returns are negative. That is why increases in tax rates now cause reductions in revenue. The tax base is discouraged. Other activities, that are “second best” but relatively more tax-efficient, become relatively more attractive to capital and entrepreneurial attention.

Increases in regulatory burdens discourage productive investment and tend to limit the capacity of the tax base. They also reduce the flexibility of everyone in business. We are all hindered in our abilities to adapt to changes in natural conditions, both economic and physical.

This helps explain why economic activity takes longer to “recover” from some downturns than from others. The response to the most recent recession is an example of government increasing the burdens on, and reducing the flexibility of, the productive sector.

As regulations and payroll taxes increase the cost of employing workers, business owners delay hiring and employ fewer workers. They might even decide to change the types of labor they employ in order to change their production and delivery processes. This also forces workers to adapt, often at great expense.

In sum, tax and regulatory increases tend to reduce the returns on stocks, bonds, businesses, and labor. That also reduces the prices and wages that people are willing to pay for these assets and services. This does not mean that we will not see those prices rise over time. It just means that the values will not be as high as they could have been.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010