Corporate tax burden cries for new leadership

Thursday, August 21, 2014

By Farrokh Langdana, Director, Executive MBA Program & Professor of
Finance and Economics

Faculty Blog:

Death and taxes

Japan does it again

Once again, a tax hike pushes Japan back into recession, just when the country was trying to recover. The three to eight percent (and soon to be 10 percent) tax hike took a heavy toll on household spending, contracting the world's third largest economy by 6.8 percent from April to June. Private consumption (C) dropped by five percent, and C makes up 60 percent of Japan's economy dealing a severe blow.

Japan is in good company. With the United States combined federal-state statutory tax rate of 39.1 percent, we have the highest corporate income tax rates in the developed world.  The OECD rate (our competition) is about 25 percent. This has compelled many U.S. companies to relocate their headquarters to lower tax countries.

Below is a very low-intensity tax "primer” to help understand the folly of our policy.  

T is tax revenues in $ or Yen or any currency of your choice.   

T = tY, where t is the tax rate as a percentage, and Y is national income

So if the tax rate t is 40% and national income is $1,000, then T, tax revenues, will be $400.

More revenue please

Now if a government decides that it needs more tax revenues, a la Japan or Obama, it raises the tax rate to say 50%. They expect to get T = ty = (50%)($1000) = $500, higher tax revenues.

But very often, this doesn't happen. As soon as the higher tax rates are enacted, or even announced, the economy contracts, and Y may fall to $750. Consequently, instead of obtaining $500, the government now gets just (50%)($750) = $375! The mistake, made over and over again by policymakers, is that Y is NOT fixed, but endogenous. It shrinks. They are trying to get a larger slice of a smaller pie. 

The classic example was during the Great Depression when policy makers raised income taxes to shrink the budget deficit, with the highest bracket going from 25% to 63%. Tax revenues plunged and the budget deficit actually increased instead of shrinking!

Way better to lower taxes (t) which would increase ecomomic activity and the national income (Y) leading to more tax revenue (T), the goal in the first place.

So how will this end?  In the past, as a student of History, I have observed how a Great Leader has always stepped up when the USA has had her back to the wall - Washington, Lincoln, FDR, Truman, JFK, Reagan. This time, the entire planet has its back to the wall and cries out for leadership. We wait for a champion. The silence is deafening.

Economic Recovery Graveyard

TAGS: Business Insights Executive MBA Farrokh Langdana MBA