The Real Laissez-Faire

Apart from the level of taxes...

I am still in the midst of my Mises Month, reading and parsing the Mises Daily email and learning about Austrian economics. But today's Daily merits special attention. The article, by Art Carden, rejects the notion of rent control.

Carden says rent control "ignores the information-transmitting function of prices." That got me thinking about how strict the Austrians are regarding free-market principles. But even Austrians fall short, when it comes to taxes.

You've probably heard there are tax benefits to having your own business -- benefits you don't get by working for someone else. Yeah: You get to "write off" most of your expenses.

Jerry and Kramer once did a bit on Seinfeld about write-offs. In the end, both of them admitted they didn't know what a write-off was, with Jerry wishing he could get the last 20 seconds of his life back.

Well, a write-off is income not subject to income tax. A business lunch, a company car, travel expenses -- as business costs, they come out of your taxable. As a rule, business expenses are not subject to income tax. This means, if your tax rate is 25%, that you save 25% on everything you write off. It's like getting a rebate on everything you buy.

That's why, in every business office, turning in receipts for expenses is such a big deal.

Excerpt Wikipedia...

In income tax calculation, a write-off is the itemized deduction of an item's value from one's taxable income. Thus, if a person has a taxable income of $50,000 per year, a $100 telephone for business use would lower the taxable income to $49,900. If that person is in a 25% tax bracket, the tax due would be lowered from $7,481 to $7,456. Thus the net cost of the telephone is $75 instead of $100.
Wikipedia, "Write-off", 6 Aug 09

When tax time comes, your accountant says you've got two million dollars profit here, you're gonna have to pay half a million in taxes. So you go out and buy a million-dollar machine and expand your business. Now you've got only a million left over, and your tax will be a quarter-mil. By spending a million dollars at the last minute, you cut your tax by a quarter-million. So the tax system gave you a 25% rebate for buying that machine.

The tax advantage is, you don't pay income tax on the income that you sink back into the business. That means, the size of your tax advantage depends on how much your business spends. The more you spend, the bigger the tax break you get. Plain and simple. The existing business tax favors bigness.

Why do companies merge? Tax advantages. Why do big-box stores put mom-n-pops out of business? Tax advantages. Why do companies like Microsoft grow from major players to industry giants? Tax advantages. Why do companies grow beyond their economies of scale? Tax advantages.

So how come the Austrians never point out how badly the tax system skews things in favor of bigness? Nobody points it out! Eh, maybe they didn't notice. Surely Congress didn't notice. If they did, they could tweak the system to eliminate the tax advantage for bigness. And then they could stop worrying about anti-trust and mergers.

Now if we're doing science here, good and bad don't count. Still, the reason to study economics is to improve the economy, to make it better. A tax system that gives the biggest advantages to the biggest players just doesn't sound very good. One wonders why such a system would be established.

They did it to stimulate the economy. The existing business tax structure is a driving force for spending. It provides a built-in economic stimulus to the private sector that helps our economy grow. As I understand it, this is the reason our business tax code is the way it is. Perhaps the "bigness advantage" is an unintended consequence of the desire to stimulate business spending. That, I can't say.

One more criticism of the Austrian school: Over and over they tell us that monetary policy (stimulating the economy by printing money) does more harm than good. But the Austrians never say anything about how tax policy (stimulating the economy with tax breaks for spending) does more harm than good.

The existing business income tax encourages spending. There is a problem with that. The problem is, the encouragement of spending contradicts and weakens monetary policy. When monetary policy is trying to fight inflation, spending needs to slow down. But the tax system doesn't care. When monetary policy raises interest rates to fight inflation, the tax code says go ahead and borrow anyway. You can write it off!

Net result: The ineffectiveness of monetary policy means inflation doesn't go away. It also means that to reduce inflation further, the policy must be strengthened. Interest rates rise higher when they rise, and the quantity of money is more tightly restricted. Meanwhile, the tax code continues to encourage the growth of spending. And when there's not enough money to spend, the tax code supports the expansion of credit use.

Monetary policy may say Whoa! but tax policy says Go! Monetary policy takes money out circulation but tax policy encourages the use of credit. Monetary policy pushes interest rates up but the write-off rebate more than covers the extra interest cost. The spending incentives of tax policy undermine our anti-inflation policy.

The contradiction between these policies is the driving force behind the growth of debt. This is the heart of Arthurian economics. Monetary imbalance -- the excessive reliance on credit, relative to the the quantity of money in circulation -- is a direct result of policy.

But that's not all. Taxes are dis-incentives. So a tax on business profit is a disincentive that drives profit down. It drives profit down, and spending up. The result is a decline in the profit margin, a decline in the rate of profit, a decline in return on investment. This decline is another direct result of the existing business income tax.

It drives the rate of profit down and the size of business up. And what happens then? Well, ExxonMobil can earn $1865.69 per second when its profit margin is no more than reasonable.

In my million-dollar example above, the company cut its taxes in half. But the company also cut its profit in half. It grew, but it was less profitable. And when companies are less profitable, they are less likely to grow. This is especially true in hard times, when we are most in need of growth. The business tax is self-defeating. It undermines its own goal. And that's why Congress is never done strengthening the tax incentives, never done trying to improve economic growth. Their method is self-defeating.

The consequences of our write-off tax system:

• The system provides a substantial tax rebate for business expenses. This tax advantage favors bigness by giving the biggest rebates to the biggest spenders.
• The tax system provides an "unnatural" stimulus, comparable to printing money.
• The tax system conflicts with anti-inflation policy and weakens it.
• Together, the tax system and anti-inflation policy drain money from circulation while encouraging credit use -- thus creating an imbalance in our monetary system, an imbalance visible today as debt and evidenced by the disproportionate growth of the financial sector over the last 40 years.
• The tax system drives the profit margin down. This is bad for business. It makes us less competitive and it leads to slower economic growth.

I'm no accountant, but if I have it right a business can write off almost all of its expenses, including advertising and lobbying costs and fines for bad behavior. Meanwhile, Congress talks up wanting to "help small business." Well, Congress could help small business by leveling the playing field: by removing the tax advantages of bigness.