EconTalk: HOW Taxes On Businesses are Bad

So me and another guy are talking about taxes, tax codes, loopholes and raising taxes on the rich. “Balanced approach,” and whatnot. Raising taxes on rich people, even business owners, is no problem. They can afford it. They’re rich, after all. Taxing businesses is basically siphoning off money that they can’t use, and can be put to better use now. He says:

The price has nothing to do with any of the existing taxes; it is simply determined by supply and demand. That’s econ 101.

Well allow me to retort!

He indeed stated the “Econ 101” lesson that the price of a good is determined by supply and demand. That is correct. But that’s an oversimplification. Let me explain the “Econ 102” answer:

Assuming no negative prices on goods, the price that a consumer is willing to pay for a good is 0 –> X. The price that a vendor is willing to sell a good for is Y –> ∞. Particularly, let’s look at Y, the minimum value for which a vendor is willing to sell his good. How is this value determined?

The final price of each widget is clearly, partly, the vendor’s own perception of what his time is worth. That’s somewhat subjective and flexible, but not entirely a crapshoot. He is not working for charity, after all, and wants to be paid for his time. But in much larger part, the final price of the widget also includes the objective costs of consumed raw materials, capital used to create the widget, rent/lease/interest paid on said capital, wage costs of the labor hired to create the widget, etc.

Now all those things (in that last sentence) combined result in A, the absolute minimum price that can be charged on the widget in order to simply break even, and make no profit. Add in the possibility of the owner wanting to pay himself a little salary to buy basic necessities (food, shelter, ulcer medication, etc.), B, and you are left with A+B=Y, the minimum realistic price that can be attached to the widget. Profit above and beyond that is, according to a cynical man’s mind, put directly into the pocket of the greedy executive. In some cases, this is true, but more often than not it is largely put into growth, innovation, expansion, etc.

At any rate, this value Y that I drew out is, in a competitive market — a market in which there are multiple vendors in an environment which contains no artificial price controls — each vendor has his own value of Y based on his own costs. And each is (obviously) trying to outsell his competitor, so each vendor will attempt to price Y as high as he can without pricing himself above his competitors. Competition naturally and favorably creates a game of economic chicken, where competing vendors charge the lowest prices they can afford, all the way down to Y, perhaps. The vendor that has obtained the lowest value of Y through finding the best deals on raw materials, finding the most business-friendly location to set up shop, etc., has the greatest advantage because he can limbo lower than any nearby competitor.

But what if one of the components of A (the largest component of Y) changes in value for everyone in the surrounding environment? An easy example is if a state raises the property taxes for industrial/commercial zoning. The overhead costs, A, for widget makers in that area increase correspondingly, and the value of Y increases, as well, for all widget makers that continue to do business in that state. Thus, the additional taxes simply result in additional costs for the vendor, higher prices on the final goods for the consumer, and often the trimming of profit margin that would otherwise have been put towards the growth, innovation and expansion that I mentioned earlier.

The final point here is to note that a business transaction can only take place if Y is less than or equal to X (X being the highest price the consumer is willing to pay). If a vendor ever experiences a surge of additional costs that push his value of Y to the right, then successful business transactions will be more rare, profit margin decreases, business expansion and new hiring draws down. Pushing far enough to the point where Y > X actually leads to the situation where successful transactions are no longer made, and the business must then either overhaul its business model or die.

Consequently, saying that the price of a house has nothing to do with embedded taxes is patently false.

***

Saying smartly that “supply and demand” is how prices are determined is technically correct, to a point. It’s far too shortsighted, however. There are fundamental and underlying concepts that one misses if they simply say that. I’ll tell you what sort of business owner determines “supply and demand” as his governing principle without doing the sort of analysis I illustrated above.

One that fails.

He is one that gets an idea, starts a business and sets a price for his widget (almost arbitrarily… perhaps by looking at nearby competitors and undercutting them by “a bit”) without ever realizing why he’s not able to hit a price that both the market is able to support and maximizes his profits.

So many businesses fail in their first few years, and my suspicion is that a significant part of the reason is exactly the topic I’m addressing… poor business planning through the blind belief in the overarching principle of “supply and demand.”

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5 Responses to EconTalk: HOW Taxes On Businesses are Bad

  1. Uke says:

    Now I know, I know that this is all commonsense, and common knowledge to the Revoistas. But it’s the sort of thing that sometimes (read: often) needs to be laid out to those people that routinely insist on raising taxes on business, not seeing how it can possibly be a counterproductive effort.

    The never ending chant of “tax the shit out of ’em” gets tiring, you know.

  2. Cornbread says:

    Sadly, ECON102 is not a required general studies class.

  3. R.D. Walker says:

    Simply put, a business won’t sell any product for a price below marginal cost. When taxes drive up marginal cost, some products will not be sold. The remainder have a higher mean price. Thus taxes drive up average prices.

  4. Uke says:

    Sadly, ECON102 is not a required general studies class.

    Goddamn well should be. But this (probably) wasn’t actually from Econ 102. I don’t remember from which of my Econ classes this was; I was just teasing the guy I was talking to after he was trying to “teach me Econ 101.” Funny how that worked out.

    Suffice to say that it should be understood by every yahoo that tells us that hiking up taxes doesn’t harm anything.

  5. Kenneth says:

    That’s actually part of 101 if I’m not mistaken. Unfortunately, it seems to be a lesson often missed.