How Do You See on the Left Side of the Classroom?

Part I: Taxes

I propose that “taxes” are money extracted from the people for the purpose of running the government and providing for the common good. As such, it would make sense that to provide the maximum “common good,” the maximum amount of revenue should be generated. (I shall not address how the tax money is ACTUALLY spent, and I shall only consider “income taxes.”)

The obvious question is: “What rate of taxation should be applied in order to achieve maximum revenue?”

A superficial response would be, “The maximum possible.” A little thought will show this to be incorrect. Consider a 100% income tax. Very little revenue would be obtained, since no one would work if all of their income were taken from them in taxes. In like manner, a 0% tax would achieve no revenue since NO tax would be taken. The “revenue curve” looks like an “inverted U,” or perhaps a “bell curve.” Clearly, some percentage “in between” must be the desired number/percentage. I believe no one knows that number — i.e., it is unknown.

Let us consider some “standard” economic assumptions:

  1. People work for a salary — as many hours as they wish.
  2. People play and receive no economic benefit for doing so.
  3. People would rather play than work.

Let us now consider a lawyer who wishes to have a load of firewood. Consider:

  1. The lawyer makes $100/hr.
  2. The wood costs $100.
  3. The tax rate is 90%.
  4. The lawyer can cut and split the wood himself in 5 hours.

The lawyer has two choices. He can work and make enough money to purchase the wood, or he can cut the wood himself. In order to purchase the wood, the lawyer must work for 10 hours and make $1,000 in order to pay the taxes of 90% and have $100 left over to purchase the wood. On the other hand, the lawyer can go out and cut the wood himself in 5 hours, and have 5 hours “left over” to “play.” The choice is obvious. At this tax rate, the government receives no tax revenue.

Let us now consider a tax rate of 50%. Under this assumption, the lawyer need work only TWO hours to make $200, pay the taxes of $100, and he will have $100 left over to purchase the wood. The lawyer will have 3 hours “left over” to “play.” The person selling the wood will be paid $100. Under this tax rate, the government will receive $150 in taxes-$100 from the lawyer and $50 from the wood supplier. An additional gain is that the woodsman has an “extra” $50 which he can use to purchase goods and services which will generate an additional $25 in taxes.

For the above example, the “break even” tax rate for the attorney is 80%, where he works 5 hours either way. The “best” tax rate will vary from person to person and task to task, but there IS SOME (UNKNOWN) OVERALL OPTIMUM RATE FOR THE COUNTRY AS A WHOLE.

The above example is an explanation of why LOWERING the tax rate may actually result in MORE revenue — in spite of the ignorant claims that “It makes no sense.” Clearly, it does not HAVE to work as it depends upon where the present tax rate exists on the curve relative to the optimum rate-but it DOES “make sense.” People who claim otherwise are grossly ignorant of economic theory.

Part II: Inflation

Consider a population of people such that each has $1,000. They trade with each other and there are just enough goods and services to survive. At the end of the month, each person ends up with $1,000-and the cycle is repeated. Suppose the government imposes a 50% tax on this population, and removes $500 from each person. What effect would that have on the standard of living of the population? If you think about it, it will have NO impact — all prices will simply be halved. In like manner, doubling the amount of money available to each person will simply double the price of everything. There would be no change in the standard of living.

Let us now consider a situation where only SOME of the population is given $2,000. Clearly, these people are at an advantage in that they can purchase MORE goods and services than their neighbors. In doing so, they drive the price up to where their neighbors will suffer a decreased standard of living. Clearly, when the government infuses money into a certain segment of the economy (stimulus), it benefits that part of the economy. Due to the influx of money, prices in all sectors of the economy rise as those who “benefit” drive prices up as they spend the money.

Consider a “benign” 3% inflation rate. Over a three-year period, the cumulative inflation will be about 10% (with compounding). Intuitively, one would think that one needs a 10% raise over three years to accommodate that inflation. Such is NOT the case-for (at least) two reasons:

1. Unless you receive your raise at the “start” of the inflation cycle, you must tap into your “reserves” as prices rise UNTIL you get your raise. At that time, you are “back to where you started,” but you suffered a decreased standard of living up to that time or an unrecoverable monetary loss. (Of course, if you receive your raise at the START of the cycle, you are “ahead” in some sense. Since the government is “creating” the money it is always at the “start” of the cycle, and thus always benefits.)

2. Due to our tax structure, most people pay about 50% in taxes. (How much of your last raise did you actually see?) Since you pay your bills with after tax dollars, you will need a raise of 20% in order to have 10% left over to pay your bills. This is quite insidious as will be described in Part III.

Part III: Minimum Wage

I do not enjoy “picking on” minimum wage folks, however they are the best example. In trades, businesses, services, etc. management and labor “come together” and “share” the profits. In some cases labor chooses to reduce their “share” because the business is not doing well. Labor would much rather have a job that paid less than have no job. Minimum wage is “different,” as it is imposed by the government regardless of the effect on the business and with no negotiation.

One of my left wing friends once said that he would “Not mind paying a nickel more for a hamburger so that the employee could make $1.00/hr more.” My first thought was, “Why don’t YOU pay TEN cents more and I’ll keep paying what I’m paying now. Why do you think you can speak for me?”

My second thought was, “Let’s look at the numbers.” In order for the person to make $1/hr more, the owner is going to have to pay about $2/hr more due to benefits, social security, medicare, unemployment, disability, leave time, etc. Thus, the employer is going to pay $2/hr more so that the employee can get a raise of $1/hr and realize a raise of $ .50/hr more after taxes.

The next thing that comes to mind is that to simply “break even,” in order to pay that $2/hr, that employee is going to have to sell about 40 hamburgers PER HOUR at 5 cents additional cost per hamburger. Furthermore, for every employee at the cash register, there are (at least) two (and more likely three) employees in back preparing the food. Thus, at a nickel per hamburger more, that store is going to have to sell about 150 hamburgers PER HOUR-if there is only one person at the counter. I suggest this is highly unlikely. It always amazes me how people can pull numbers and “facts” right out of thin air to support what they think is “right,” and then IMPOSE THAT SITUATION UPON OTHERS WITH IMPUNITY AS THEY WILL SUFFER NO ILL EFFECTS REGARDLESS OF THE RESULTS; AND THEY NEVER LOOK BACK TO SEE THE HAVOC AND DEVASTATION THEY HAVE CAUSED. When confronted with the results of their actions, invariably the response is, “Well, you’ve got to break a few eggs to make an omelet.” Funny thing, they are always talking about someone else’s eggs.

Let us consider a more general case. In general, small business must make about 20% profits to survive. The “high” profit is necessary because of the high risk-with something like 80% of the small businesses failing in the first five years. Now, in order to give an employee a $1.00/hr raise, it will cost the employer about $2.00/hr (as stated above). In order to “break even,” the employee must sell an additional $10/hr of goods/services, or about $80/day. (If one assumes a 10% profit margin, then the employee must sell $160 more per day.) Such is unlikely to happen, so the employer must raise prices in order to accommodate the pay raise. He cannot simply raise the prices by the amount of the pay raise because of his increased costs beyond the raise-he must raise prices by (at least) DOUBLE the amount of the pay raise. (Of course, depending upon the business, the employer’s wholesale costs may also rise because of the increase in minimum wage, which may result in greater price increases in order to maintain the profit margin.)

Interestingly enough, while the employer is raising his prices by (at least) TWICE the pay raise, the employee is seeing only HALF the pay raise because of taxes. As the price increases reverberate throughout the economy, it can cause some hardships — on the very people it was designed to help. Because of their “pay raise,” the employees actually “lose ground,” so demand a higher wage-and a new cycle begins.

Consider that typically product costs are 2/3 labor. If a merchant increases his labor costs 20% (10% to the employee, 10% in benefits/taxes), then the price of the product will increase by 2/3 of 20% or about 14%. The employee will receive a 10% raise, of which he will “see” 5% due to taxes. As such, product prices will increase by 14% and the employee’s wages will increase by 5%. This presumes no increase in raw materials costs due to a general minimum wage hike.

It is even more sinister in that because the minimum wage folks get their money “first” in some sense, they believe they are “getting ahead,” but as the effects permeate the economy, they gradually lose ground without realizing it. As previously stated, quite insidious.

Part IV: Conclusion

The careful reader will note that I have placed no “value judgment” upon this situation. I have simply taken what I consider to be “reality” and described it through numbers. What is most interesting is the reaction I get when I state the contents of this paper to left-wingers. It ranges from, “That’s not true,” to “I don’t believe it,” to “You’re a brainwashed neo-con.”

When I attempt to converse with such people, they often scream, shout, and launch personal attacks. They will not (can not?) address the underlying rational discourse. I cannot state that my statements are true — I can state that they have yet to be refuted.

Tony De Maio

December 15, 2009

The Daily Reckoning