Taxes. Fun.

April 29, 2021

When it comes to taxes, societally we're probably under-discussing Newton's Third Law of Motion.

As a refresher, that's the one that says "for every action, there is an equal and opposite reaction." When you tax something, there is going to be a reaction. It might not be equal, but it will exist.

This is important, because policy-makers love to pretend that this is not the case. There is always some reaction, and in economics, these reactions tend to work on curves. Here is one way to think about it. If a tax rate is at 30% today, and that rate is raised to 100%, there would be no reason to work unless you love your boss as much as the employees at One Day In July. People do not wait until the last percentage change, from 99% to 100%, to alter their behavior. Unlike activation energy in chemistry, or static friction in physics, in economics, human behavior tends to work on curves.

So that is base point #1. Base point #2 is that no one really knows how to measure the unknown, or opportunity cost, or "value of doing something else relative to what you are doing." When I read an academic economics paper, I first try to convince myself that I can skip all those mathematical summations, that I can always go back and figure them out. By the end of the paper I'm skipping most of the paper, but console myself that it's probably wrong anyway because of the difficulty of measuring opportunity costs.

Taxes fire up lots of people! Instead of the classical arguments, let's look at two effects that rarely see media discussion.

1. Tax Rates on Corporations. The 14th Amendment, intended to abolish slavery, by way of a court reporter's footnote in Santa Clary County vs Southern Pacific Railroad Co led to the concept of personhood for the U.S. Corporation. From an accounting perspective corporations get interesting. If you raise a tax rate on a corporation, you are not applying an equal standard. Many expenses are paid by certain types of companies after taxes. For example, all that inventory in retail stores? That is bought, initially, with after tax-dollars. Most expenses in a law firm? Before tax.

If you raise the rate on this corporation-who-before-the-court-reporter-was-not-a-person, and if the business happens to be in an industry that underfunded its lobbyists, it now needs to find funding somewhere else to expand. It may not be able to do so on its own, now-reduced cash flows. The financial industry does not complain about this opportunity, as it creates a new customer for lending, and control transfers from the business to the financiers.

2. Silos of Capital. When the private equity folks are not making lots of money on the new business channel in #1 above, they can use their spare time to complain that the higher tax rates on capital gains will harm their hundred-million-dollar take-home pay. This pitch has not sold well with the American public so they have rebranded it as "harming investment in startups." Here it gets interesting, because they're not entirely wrong.

Remember the first point of this email. Behavior works on curves. Here, the investors needed for the startup have to move the capital from somewhere else, and in many cases, when the tax is higher, they are reluctant to move it. The startup would have to have an even higher expected return, and most startups fail. So inefficiency is created in the economy, as capital is now trapped in assets that may not create innovation, and may not be optimal. Transaction friction silos capital into non-optimal positions, and there it sits.

A prominent counter-argument is that Red-Bull fueled entrepreneurs do not think about capital gains when they form a business. Red-Bull fueled entrepreneurs think about code and crypto, not boring things like taxes! Again, things tend to work on curves. And Isaac Newton has a funny habit of showing up.

We have this capital friction problem every day at One Day In July. As new clients join, often in securities that we don't favor, we have to decide whether to leave the position or sell it and recognize a tax hit. Because the tax is rarely zero in a brokerage account, many times capital gets siloed in places that enrich the financial industry even more.

It's a minefield out there when you bring up taxes! The opinion writers on the pages of the NY Times and the Wall St Journal have found perfect clarity on the topic. For the rest of us, in practice this is more like whack-a-mole.

Dan Cunningham