Monday, July 1, 2013

Higher Taxes - Your Business at Risk

Naive business owners think that excessive taxes don't hurt their business. Experienced managers disagree. This is why large businesses, those managed by seasoned leaders, do everything to reduce their tax burden while small businesses don't.
Photo of yellow sign with legend "In Case of Zombie Attack Pull Cord..."
Look-out for zombie companies
The solution to the disagreement lies at the margin. Taxes come out directly from the business' bottom line. As a result, changes in tax rates push any marginal business into bankruptcy. Let me explain.
Businesses that can't make a profit disappear, period. So we will deal only with the survivors. From those that continue to exist, a simple statistical distribution analysis will show that most reside near the margin. These living-dead businesses operate around the zero profit line over time; just making enough to continue to operate another day. They see times when money is lost; times when they quickly burn through cash reserves. Then there are those times when they regain the money needed to replenish the lost cash. The effects from such cyclicality vary depending on the industry.
Car makers, for example, see times when earnings are so good that everyone, including their labor unions, negotiate better deals, But the inevitable industry slow down seems to always catch them by surprise, triggering all sorts of emergency plans to save the business. If it were not for the special privileges they secure during these tough times, these factories would disappear.
Insurance companies see similar patterns. Low casualties result in exceptional dividends most of the time. Then, a catastrophe somewhere forces them to request emergency help to ensure that their reimbursement funds are not wiped out.
Photo of old classical style building with "Insurance" carved on its facade
Insurance Company
But small businesses don't have anyone whom to run to for help. If anything, their cost of capital increases during difficult times, making a recovery even more difficult. Cash can get so expensive to the small business that it easily overpowers all profits.
Yes, like insurance companies, when business is good, these companies return acceptable profits. Unfortunately, it is the down cycles that are terminal for many.
And then there is the timing of tax increases. Taxes usually increase when government is not getting enough in collections, which happens during economic slow downs. This means that the time when marginal businesses face the most risk, their funding gets much more expensive and uncle Sam demands additional confiscation.
That's when a small change in net after tax profits of just a few points will have a disproportional impact in the number of surviving businesses. As soon as cash reserves are depleted, a situation that's even worse during long recessions, many businesses will seize to participate in the market.
Photo of glass jar with white "Taxes" label and a few one hundred dollars inside
I am therefore not talking about whether businesses should shoulder their civil responsibilities or not. It's a matter of life or death to the businesses just hanging on. Let's remember that, when a marginal business closes its doors, several non-marginal jobs also disappear. Consequently, economic losses multiply when employees are accounted for.
It also doesn't mean that politicians can't ever raise taxes. A politician who understands business-drivers can find ways to compensate for the losses. For example, an increase in taxes that's matched by a decrease in regulation will give businesses the ability to innovate their way into newly found profits. Since regulations raise barriers to entry and stifle innovation, their absence could do the opposite, thus creating the new opportunity.
Although workable, a trade between increased taxes and less regulation would not be symmetrical. Higher taxes would be certain plus would lower profits and cash in the short term. Innovation, on the other hand, is not certain. Moreover, any cash that results will take a long period to materialize. This unbalance creates the need for cash float; which a smart politician could also solve while structuring the trade.
The resulting asymmetry in certainty and in duration would make the outcome for the business similar to that from other capital investments. Thinking about it, by offering to reduce regulations, government is indirectly driving businesses to increase CAPEX; which would be invaluable for the economy in the long term. While not an ideal trade, government wins, the economy wins and companies win; all thanks to business innovation and a little bit of patience.
Also keep in mind that this trade-off isn't the only tool available to politicians. I just gave an example. There are thousands of possibilities. All that's required, as I suggested, is that politicians understand business drivers.
Unfortunately, this is something that the present White House has demonstrated to be impossible. They either want to do the right thing but are incompetent or are very competent but do not want to do right. I'll let you chose which is better.
Red poster with legend "Last Day" "after 104 years" "Sun" "your business name" "going out of business" "negotiate now!!!" "your address here"
Business Closing Sign
Detractors of any idea that promises to help businesses will surely see this trade as way to promote greed. They will fail to notice the tax increase and will push for more business pain. But they would be absolutely wrong.
What would happen if all businesses disappeared? We know that people would still find ways to earn a living. Centuries ago, humans had no companies and still managed to survive. But the key word here is survive. Without businesses, productivity collapses leaving everybody with less food, less home, less clothes and less stuff. Why else would people form production groups if it weren't because groups increase individual productivity, thus raising standards of living? We must therefore protect and preserve businesses whether wealth redistributionists like Obama understand it or not.
Now that here is the next concern. What does a bankrupt city like Detroit mean to you and your business in the form of future taxes? In short, a lot. Tomorrow, we will look at the tidal wave gaining force. The resulting economic impact demands your undivided attention.

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