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July 24, 2010

How to discourage producers from producing

Imagine a company deciding to change its sales compensation plan. Rather than providing incentives for salespeople who achieve difficult quotas, it instead implements a sliding commission rate that declines as sales increase. The most talented salespeople would be the most severely impacted and human nature being what it is, they would certainly reduce their efforts accordingly. Business would decline.

The U.S. government is currently debating whether or not allowing expiration of the Bush tax cuts for high-earning individuals will reduce their incentive to spend. This, though, should be a relatively minor concern. The real problem is the reduced incentive to produce. I remember a friend of my father’s who was a renowned surgeon during the period of 70% top marginal tax rates. He would only work 6 months of the year – saying he refused to work for 30% of his money.

The taxpayers targeted by the current administration are the ones most instrumental to our economic success. Many of them are small business owners and, particularly in a credit challenged economy, need their profits in order to facilitate growth. Taxing away earnings leaves the owners with both less incentive and less ability to continue to invest in their companies. Small business is the primary driver of employment; meaning that the higher tax rates will continue to thwart economic progress.

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12 Responses to How to discourage producers from producing

  1. One must assume that the intent is to extend the economic malaise. There is no other logical explanation.

  2. Thank you for this post and the comment.
    You highlight the practical reason for continuing the Bush tax cuts. I would also like to point out the moral reason: punishing the producers for their productivity is immoral! This is true regardless of the source – it could be a government or Robin Hood.

  3. Virtual_JTW,
    I hadn’t really thought about the morality of it, and certainly the U.S. population in general appears to feel it is appropriate for higher earners to pay a larger share of their income in the form of taxes. I’m approaching the issue from the perspective of a business owner (which has been true for me a couple of times previously). I’m not sure I’d consider it necessarily immoral to pay a lower commission rate to my top producers, but it sure would be foolish for the business. Nonetheless, I appreciate your view and thank you for your comment.

  4. I think you are not quite right and you should still studying the matter.

  5. This is true regardless of the source – it could be a government or Robin Hood.

  6. Anyone else ever heard the saying: If the sales folks are NOT making more income per year then the President, there is a problem?
    One of the first fundamental truths I was exposed to when I worked in the VAR space. Generally 100% Commission.
    Always thought it made Perfect Sense…

  7. While I don’t think the ’70%’ plan fixes the budget, we do need more brackets and higher brackets.
    The sales commission analogy is just not a good one. Think of your average salesperson- they get their commission plan at the beginning of the year with their new quota. First thing they do (besides complain about how high it is and they’ll never hit it) is analyze what business they’re going to do, and how they’re going to hit their number.
    You can ask any sales person in the world they probably know the answers to these two questions before their kid’s birthdays:
    1. What’s your number?
    2. How much have you sold to date against that number?
    Now just replace the words ‘salesperson’ with ‘citizen’ and quota with ‘tax brackets’ and you’ll see how silly the comparison is. No one check’s their tax brackets and figures out ‘where they need to be’ and we currently have a progressive tax system. Tax rate has no effect on ‘producers’ producing (until the rate approaches 100%).
    This argument is as spacious and dumb as the “supply side tax cut” one- where tax cuts on businesses will cause them to hire more people.

  8. VMTyler,
    The evidence, as described in today’s WSJ article, contradicts your supposition entirely http://on.wsj.com/mlsd7X. As I said in my post, the people being taxed are small businesses and they absolutely plan around tax flow. When rates go up, they have much less incentive to expand their business and, at some point, begin contracting or shutting down entirely – it isn’t worth the work and the risk just to have it all taxed away.

  9. Steve,
    I’m sorry but an Op/Ed piece by someone from the Cato Institute in the WSJ doesn’t exactly hold much water. Much like the weather, there are more then one or two variable in play here and to try and pin tax revenues purely to rates is intellectually dishonest at best.
    I’ve worked for small businesses, owned small businesses, and consulted for small businesses. I’ve never heard of a single owner make a decision based on taxes besides “we need to spend some money before the end of the year otherwise we’ll have to pay taxes on it.”
    That’s the key point in all this- employees, purchases, expansion- are all expenses, which come out before taxes. It’s only anecdotal evidence, but in practical application higher tax rates encourage investment; otherwise that revenue becomes profit which is what is taxed, not gross revenues.
    I’ll say it again, tax rates on businesses have nothing to do with investment in expansion- increase in demand is the sole driver of business expansion, period. If demand is way up, owners find ways to expand (credit lines, loans, etc) even if they don’t have the cash. If the demand isn’t there, even if they have spare cash there is no reason to spend it on expansion.
    What business goes “you know, all our sales people aren’t really that busy and production is at 50% but I just got a tax break so lets hire more people?” Answer: None.

  10. Tyler,
    I submitted the WSJ example just because of its timing. Every study I’ve seen shows that increasing excessive tax rates has an inverse correlation to tax revenues. The Joint Economic Committee of the Congress of the United States, for instance, wrote “High top tax rates can induce counterproductive behavior and suppress revenues, factors that are usually missed or understated in government static revenue analysis. Furthermore, the key assumption of static revenue analysis that economic growth is not affected by tax changes is disproved by the experience of previous tax reduction programs. There is little reason to expect static revenue analysis to evaluate the economic or distributional effects of current tax reform proposals much better than it evaluated the Reagan tax program 15 years ago.”
    Your statement, “It’s only anecdotal evidence, but in practical application higher tax rates encourage investment; otherwise that revenue becomes profit which is what is taxed, not gross revenues.” While I have not seen any supporting evidence for this supposition, my hunch is that in certain cases it could be true assuming the business is very small (since the current deduction for investment caps out quickly), the tax rates are not egregious (meaning south of 50%) and that the business has the cash to invest. Unless all three of these factors hold true, a small business simply doesn’t have the cash to invest when the majority of it flows to the government.
    Your statement, “tax rates on businesses have nothing to do with investment in expansion- increase in demand is the sole driver of business expansion, period” is simply unsupported and, in fact, contradicted by every study I’ve seen. Check out, for instance, The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act in The Journal of Political Economy.
    You say that businesses find a way to get the cash if demand is there – but this is both an erroneous assumption and misleading. The credit crunch of the past few years resulted in thousands of small businesses retracting or closing all together because they couldn’t get the credit required to meet the demand still extant. The owners were willing, the banks were not. But more importantly, high tax rates discourage the desire for expansion even if the demand is there. In order to understand why this is so, let’s take tax rates to the logical extreme and assume they are 100%. In this case, a business owner would be completely irrational to assume the high risk and effort inevitably involved in expansion as she would receive none of the proceeds. What about 99% rates? The same reasoning applies. So where do you draw the line? A 70%+ marginal tax rate is certainly high enough to discourage most small businesses from expanding in most situations. And the very fact that small businesses don’t expand (or more likely, contract) itself causes less jobs, less demand and a spiraling down economy.
    As far as a businesses hiring sales people because of a tax break – you are correct that the reasoning probably doesn’t proceed in that manner (though it does occur that way for individual efforts as shown by the example of my father’s physician friend relayed in my post), but the result is the same. The business simply has less money when tax rates are excessive and therefore doesn’t hire more people.

  11. Steve,
    The one thing your logic keeps overrunning is taxes are paid on profits, not revenues. The business does not have less money available to itself, it potentially passes less profit through to its owners.

  12. Tyler,
    I am surprised by your comment given that you said you used to own small businesses. Your statement is typically only true for a very small business (i.e. single employee) that doesn’t sell product. Most businesses have a lag between outgoing expenses and incoming revenues to cover them. It is the profits that make up the difference and that feul the growth of the business. Even quite profitable businesses can quickly get into trouble when they have to pay a lot in taxes. Businesses that otherwise would like to expand (based upon increasing demand and profits) instead do not so that the cash flow is manageable.
    Additionally, gross profits are meaningless in terms of incentive for small business expansion. What owners care about is the after-tax earnings. When taxes increase, the after-tax earnings are slashed. Given the exceptional risk and effort it takes to operate a business, a minimal after-tax profit is not enough incentive to open more branches, hire more employees, add a new product line, etc. Indeed, high taxes discourage entrepreneurship from the start (See Tax Policy and Entrepeneurial Entry from The American Economic Review).
    It frankly puzzles the heck out of me how you and others can think that high taxes would not have a deleterious effect to the economy. Small businesses, in particular, are the engine that drives both jobs and innovation in the economy. But starting a small business is both very difficult and very risky – most small businesses don’t make it. Entrepreneurs need financial incentives to make the commitments demanded of them. They need cash flow just to survive, let alone for hiring and expansion. High taxes impede both conditions for success.

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