Why Tax Breaks Aren’t Bad

The economist Robert H Frank in his book ‘The Return of the Economic Naturalist’ completely dismisses the case in favour of tax breaks for the rich (a policy aggressively pursued by the then Bush administration). As far as boosting employment is concerned, he claims, it doesn’t matter what tax rate business owners are paying.

If the addition of another worker to the company is profitable, the entrepreneur will hire him regardless of what tax rate he is paying. This is the decision criterion of the rational utility-maximising capitalist, he says. Although Frank’s logic is extremely elegant, it is ultimately flawed.

I’m obviously not going to defend the economic policy of George W. Bush. But bear with me. In this case, the former President was claiming that tax cuts for small business owners created new jobs. The success of this policy clearly relies on the assumption that richer business owners hire more workers. Or does it?

In his book, Professor Frank responds by explaining the basic hiring criteria of any business. If the revenue brought in by another employee exceeds the cost of hiring him, the new recruit will be hired. That hiring criterion clearly exists independent of the tax rate suffered by the business owner, or his individual wealth. Thus, Frank argues that tax cuts for small business owners don’t have any impact on employment. Workers are hired or not hired either way.

But suppose we were talking about tax breaks for workers. Clearly, you are more likely to take up employment in a low-tax environment. As the government takes more of your wage in taxes, it becomes less worth-while working. If tax rates become really high, you will eventually decide to ditch your job in favour of chilling out on the beach or spending time with your family.

Why? Because workers have to decide whether the wage (benefit) is worth the work (cost) necessary to obtain it. That’s cost-benefit analysis. Similarly when they’re deciding how hard to work, entrepreneurs have to decide whether the profit (benefit) is worth the work (cost) necessary to accrue it. They are faced with the same opportunity cost of working – not spending time with their family, or not playing golf.

So claiming that entrepreneurs will always hire a worker if it’s any way profitable is like saying that workers will always accept a job if it pays any wage at all. That’s rubbish. Since they’re both rational, capitalists and labourers alike need promise of sufficient reward before they are bothered getting up for work in the morning. They are similar in that regard, I guess.

Thus, it could be argued that small business-owners might decide to work that bit less hard, and spend a little more time at home or on holiday, if tax rates are too high. But when tax rates are low, they get more benefit from identifying opportunities to expand their business – all the while generating profits and creating new jobs. Professor Frank’s reasoning holds in a world where capitalists can immediately identify profits and easily pursue them. But that’s not the real world.

In the real world, identifying profitable new paths for your business takes time and effort – that you could be devoting to other things. By making it more attractive with a tax break, President Bush was indeed encouraging small business owners to create jobs for the American economy. It’s up to your personal stance on government whether raising that extra tax revenue would be worth destroying those jobs, but claiming as Frank does that it has no effect is just plain wrong.

Of course, substituting work for leisure isn’t the only impact that changes in the tax rate have. When people get paid less because of higher tax rates, they are poorer and can afford less stuff. This might spur them on to work harder and longer hours, so they can get back to the wage they had before the tax hike. So do tax breaks really encourage small business owners to create employment? Or does it allow them to take it easy and retire earlier? This commentator doesn’t know, nor does he claim to.

© The Free Marketeer 2010

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2 Responses to Why Tax Breaks Aren’t Bad

  1. Pidge says:

    Surely there’s something driving exceptionally wealthy people beyond the mere uses of money – surely it’s the work and the increasing attainment of wealth which drives them too.

    A cost-benefit analysis which examines merely an entrepreneur’s income (and not the pleasure they get from that business, and the power/wealth attained) wouldn’t explain why Warren Buffet still works, or why nearly all Irish developers consistently put all their money on the table, even though they already had more than enough money to live their lives in wealth.

    Something tells that if you had even a 90% tax rate on the twenty richest people on the planet, they’d continue to work just as hard. There comes a point where the reward to work is not the things which money enables you to do, but money in itself, or the pleasure of the work.

  2. thefreemarketeers says:

    Nice point. I genuinely don’t understand the kind of people that you’re talking about.. They seem like more of an aberration to me. Maybe pathological workaholics are just more likely to make it to the top of their respective fields, and as a consequences they there act strangely with their enormous wealth? That’s a nice explanation.

    But the typical business owner will still be operating at the stage where income has very real benefits (better holidays, nicer cars, more comfortable retirement, better schools for children). Most people enjoy their work too, but is it the case that upper management have more enjoyable work than middle or lower management in the typical firm? I don’t think so, somehow. At the level we’re talking about there, it’s all about the wage. They work harder because they’re paid more. The guys below who work hard are doing so because they’re looking for a promotion.

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