Tax Reform: A Tax Break for Rich Corporations?

If you listen to Nancy Pelosi and the rest of the Democrats, none of which voted for the tax reform bill, or the liberal commentators in the main stream media, a common refrain (among many related themes) leading up to the vote was “…It’s simply a tax break for wealthy corporations!…We need to tax them more, not less!…These evil corporate fat-cats are laughing all the way to the bank!…” 

Many believe the rhetoric. Those who do likely also have no idea how the economy works or how value gets created. They have a warped sense of reality, particularly in terms of government’s role in the economy. If you have never run a business, or taken the time to learn how companies function, then you can easily believe what others want you to think without questioning their motives. In this case, that the government needs more of your tax dollars in order to expand indefinitely, transfer wealth so that politicians constituent’s become engorged on government largesse, and get these same politicians re-elected as a result. It is really all about power and money in DC.

So let’s take a look at a very simple profit and loss statement, commonly referred to as a “P&L”. If you understand the simple math involved, it will help you understand the fallacy in the argument against lowering the corporate tax rate. You will see that the benefit exceeds the cost.

To make it simple, I have illustrated this on the basis of a business that sells a product for $100.

Example P&L

Revenue: this is what you sell $100
Cost of Goods Sold (COGS): this includes cost of materials and labor to produce the product ($50)
Gross Margin: revenue – COGS is the margin dollars $50 $50/$100 x 100 = 50% Gross Margin %
All other expenses: this includes all the other expenses to run the business such as other labor costs for management, marketing, sales, etc. ($40)
Earnings before interest and taxes (EBIT): this is gross margin – expenses and represents an important metric to measure the performance of a business $10 $10/$100 x 100 = 10% EBIT %
Taxes at 30%: for this example, I am ignoring interest on debt ($3)
Net Income: if this is positive and growing that is good as it provides the company the resources to invest and grow; if is negative, you are losing money and you go out of business and everyone is fired $7 $7/$100 x 100 = 7% Net Income %

Before we talk about the implications of lowering the corporate tax rate, there are some important things to consider when you look at this P&L and understand how businesses actually function.

First, the company does not have complete control over how much any employee, including management gets paid in salary, despite what you may assume is true. It just does not work that way. Companies do of course have leeway in the salary that they pay, within some range, but the market sets this rate. It is simple supply and demand.

Let’s say you hire a software engineer. They are in high demand. They have a lot of options for jobs. Companies have to bid up the salary to compete with other companies looking to hire this specific skill. It is the same for every last employee, from the person sweeping the floors to the CEO. It is market based. If there is excess supply of a particular skill set and low demand, then salaries go down. If there is high demand for a skill set and low supply, the salaries go up.

To go one step further, let’s say you own a private company, or you are the CEO of a public company that is owned by stockholders and answers to the Board of Directors. And let’s say you want to pay your employees or management way above the market rate. What do you think will happen?

You are competing with other companies. In order to make the same profit, you either have to significantly raise your selling prices so the revenue goes up, or slash other expenses other than labor. In the case of raising prices, that will tend to make you non-competitive vs. your competitors, and your revenue goes down, not up. So, that will not work.

Furthermore, especially if you are a public company, the Board of Directors will not allow you to overpay your employees. And they will not want to pay you as the CEO more than they have to. After all, if they do, they will be punished in the stock market. Their investors will demand change. You see this happening all the time with public companies.

A second comment about the P&L is that those who support lower corporate tax rates will argue that “corporations do not pay taxes, they simply pass it on to their customer in the form of higher prices”. That is actually not entirely true. It is actually much worse.

Why? The same reason I cited above in the discussion on salaries and the fact that every company has competitors. And today more than ever, many of those competitors are not in the US, but in countries where either the labor rates are much lower (for a variety of reasons), or corporate taxes are much lower. (The US had until this tax bill was passed one of the highest corporate tax rates.)

Therefore, most companies cannot easily simply raise prices in order to absorb higher taxes. If you look at the P&L, if the revenue stays the same, but the taxes go up, and you want to maintain the same profit, what does that mean? It is simple math, you have to reduce expenses. For many companies, labor is the most significant cost. That usually means companies will have to reduce the number of employees in order to reduce costs.

Understanding this simple P&L will help you ascertain fact from fiction in this argument about lowering the corporate tax rates. For instance:

Lowering the corporate tax rate does not mean that owners or CEO’s will necessary make more money, any more than it means suddenly every employee will have their salary raised above the market rate. For the same reasons I have already explained. You have seen some very large companies announce higher bonuses after the tax plan was announced but that is not the same thing as raising salaries. Bonuses are one-time events and do not have to be done every year.

Lowering the corporate tax rate provides more leeway for companies to hire more employees. That is good for the economy, and good for increasing the labor participation rate. This is providing more opportunity for those looking for a job to find a job. It is true that the kinds of jobs available and growing today are different than in the past. And many do not have the right skills. Though an important issue, that is not germane to this discussion.

Lowering the corporate tax rate provides more leeway for companies to compete by lowering selling prices, increasing revenue and earnings. For instance, in the example above, if the tax rated is lowered from 30% to 20% and the company is able to lower selling prices to increase demand for their products at the expense of a foreign competitor:

Revenue: this is what you sell $105
Cost of Goods Sold (COGS) ($53)
Gross Margin $52 $52/$105 x 100 = 50% Gross Margin %
All other expenses ($42)
Earnings before interest and taxes (EBIT) $10 $10/$105 x 100 = 10% EBIT %
Taxes at 20% ($2)
Net Income $8 $8/105 x 100 = 8% Net Income %

In this scenario, lowering the tax rate gave the company flexibility to lower prices to stimulate demand, and still increase the net income. You will note that COGS and other expenses also went up in proportion to the increased sales. That is good for the economy as it likely means the company has to hire more people or pay more for overtime. Everyone wins.

Another related issue is that many large global companies based in the US but with substantial sales and operations outside the US, have set up operations outside the US (hiring workers in that country), with the profits being retained in those countries where they can take advantage of the lower corporate tax rates. When you hear of US companies who are criticized for not paying “their fair share”, with a very low overall tax rate, that is how they do it. You cannot blame them. Again, they are beholden to their share-holders.

By lowering the tax rate, those jobs will come back to the US over time. There will not be tax incentives for setting up those operations outside the US. That will not be true in all cases, as there are good business reasons to set up an operation outside the US. Maybe because of access to a specific market, or to raw material supplies, etc. But I can tell you from experience, there are many companies who have set up these operations outside the US for no other good reason other than to lower the effective tax rate.

If there are all these advantages of lowering the tax rate, then raising the tax rate will have the opposite effect. Just look at the P&L, and think through what would happen if that tax rate increases vs. decreases. It means layoffs. It means a decrease in GDP. It means less tax revenue. It is simple math.

Jeff Groh is a fiscal conservative and a social moderate. He believes more often than not, both sides of the political spectrum agree on the ends, but it is the means that fuel disagreements, with the far right and left resorting to name-calling rather than a pursuing a rational debate on the issues, trade-offs and unintended consequences. He is also District Captain in NC 113 for the Convention of States Project. His consulting company, New Product Visions, helps companies improve their innovation management practices, and he is passionate about the creation of economic value and prosperity by restoring our country’s manufacturing base. Want to email me? jgroh@newproductvisions.com

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Tax Reform: A Tax Break for Rich Corporations?

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