Business 201: Why Low Tax Rates Matter

With Pres. Obama’s reelection, political stem winders are focused on ‘The Fiscal Cliff,’ as the enacted package of reductions in the growth of government and tax increases to above Clintonian levels is called. Few Republicans are willing to play hardball and face sequester, but at least some are insisting on new revenues through eliminating deductions rather than raising marginal rates. While Shout Bits is certain Congress will find a way to do worse than just driving off the Cliff, here is a primer on why keeping marginal rates low is important for everyone.

Money never rests. Apart from the wad of cash in America’s pockets (M0 which is .8% of all cash like instruments), every dollar is invested toward economic growth. Even those who simply put their cash in checking accounts are allowing their banks to lend that money to businesses and homeowners. While some of the upper-middle class, whom Obama calls ‘rich,’ keep their money in banks, many invest their cash in businesses directly.

Perhaps what Obama does not understand is that business cannot grow without reinvestment of its earnings. Growth cannot happen without investment; it is not magical. Long term, without raising outside equity (i.e. issuing new shares of stock), a business can only grow at the rate of its return on equity (assuming no dividends). Whenever a business raises new equity capital, that money comes from other less profitable sources, so new investments are a zero sum game at the macro level. Growth comes only from reinvestment of return on equity (which further explains why QE3 and stimulus can never work).

To achieve growth, therefore, return on equity should be maximized. Investment analysts often look to the DuPont Equation:

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)

To save Shout Bits’s readers the headache of interpreting the equation, it basically says ROE is maximized by running a tight ship, applying assets carefully, and selling the most profitable products. Also, Net Profit is after tax, as there are no accessible pre-tax profits (i.e. the government gets its cut first). Assuming businesses are trying as hard as they can to maximize the components of the DuPont Equation, the remaining variable is taxes.

If tax rates go up, ROE goes down, slowing growth. Greed, as Obama calls it, has nothing to do with it. The ‘rich’ do not keep their money in mattresses, they reinvest it in growth. The one thing the ‘rich’ like to do is get richer. While Obama may hate capitalists and seek “revenge” and “punishment” against them, they are also the source of economic growth, which the US desperately needs.

This is why, if the government must have more tax dollars, eliminating deductions and preferences is the better way to go. Especially in the corporate realm, tax preferences are a way to enhance growth at the expense of others (assuming the tax preferences are paid by raising marginal rates or marginal rates could be lower without the tax preferences). Those who lobby well are allowed to grow faster than those who focus on less valuable tasks like serving consumers.

Gov. Romney’s proposal to keep the Bush tax rates but cap total deductions was a pleasantly pro-growth proposal. It limited the amount by which the well-connected could achieve earnings growth compared to the non-political class. Overall, such a proposal would grow the economy faster than one with high rates and innumerable preferences. Some Congressmen from both parties have teed up Romney’s concept.

Low marginal rates are not a favor to the rich, although they obviously would benefit. Low marginal rates are a pathway to economic growth and thereby better employment for the ordinary citizen. Not a theory, but solid well tested math, low tax rates, higher ROE, and economic growth are all tied together. Voters should encourage GOP leaders to negotiate toward keeping rates low as they cut a deal with Obama over the Fiscal Cliff.

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