Tuesday, 2 February 2010

Taxing profits does not discourage entrepreneurship.

The knee jerk reaction of Republicans and other economic conservatives to any proposed increase in profits tax is that this discourages “wealth creation” or entrepreneurship. This idea is flawed.

The first weakness in this argument is the Laffer Curve: that is, the higher the rate of tax, the more the effort put into avoiding and evading tax. But even assuming employers are entirely honest, and happy to pay any amount of tax, increasing tax on profits still won’t discourage entrepreneurship.

A tax on apples WOULD discourage the production and consumption of apples. However, this sort of reasoning does not apply to entrepreneurs and for the following reasons.

Apple sales probably make up 1% of GDP or less, thus apples are microeconomic. In contrast, when considering entrepreneurs (that is, ALL entrepreneurs in a given country) one moves into macroeconomics: a totally different ball game. (I'll assume constant aggregate demand, by the way: i.e. assume any increase in tax is matched by an equivalent increase in government spending.)

A nation’s entire output flows through the hands of its employers. That is, the proceeds of ALL goods and services sold flows through their hands. Thus when considering employers (that’s ALL employers in a given country), one is into macroeconomics.

It could be argued against the above that entrepreneurship involves risk taking and a significant proportion of “employers” nowadays are state and local government, and other public sector entities, and that running these operations involves relatively little risk for those involved. Thus these entities are not really entrepreneurs. That is true. But it still leaves an awful lot of money, indeed the majority of GDP in most countries, flowing through the hands of “genuine entrepreneurs”.

Certainly the INITIAL effect of an increased tax on profits is to discourage entrepreneurship. A portion of entrepreneurs will react by seeking alternative employment: as employees rather than employers. Some will flee the country, and seek employment abroad, plus some will seek jobs in the public sector. And the employees of the employers who have “given up” will become unemployed.

But assuming constant aggregate demand, the demand met by former entrepreneurs will shift to those who have decided to remain entrepreneurs. The latters’ profits will rise. And that will encourage some of the “quitter entrepreneurs” to return to running businesses.

Indeed, is there anything to stop post tax profits returning to their former level? Post tax profits certainly NEED to return to this level if a country is to have an optimum number of employers, because it is post tax rewards that people look at in deciding between different forms of economic activity, not pre-tax rewards.

The only thing to stop post tax profits returning to their previous level would be some sort of interference with market forces. Something along these lines was in evidence about thirty years ago in the UK: British trade unions often cited profits and the pay of the self employed as justification for wage increases. Where a country’s workforce is heavily unionised and unions demand remuneration for their members that is fixed relative to profits and the pay of the self employed, then the relevant market forces are thwarted. However, this trade union behaviour is less evident nowadays in the UK.

Conclusion: increasing the tax on profits does not discourage entrepreneurship because pre tax profits will rise to whatever level is required to bring post tax profits back to the level that obtained before the tax increase.

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