March 4, 2011

Maryland gas tax:
Taxing profits vs. taxing costs

A few days ago I wrote against the Maryland gas tax proposal from the fairness angle. The following is an argument against the MD gas tax from the efficiency and competition angle using the perspective of a business owner, as opposed to the traditional analysis of the consumer who is hit at the pump.

Broadly speaking, there are 2 kinds of taxes that businesses pay: Taxes on profits, and taxes on business-costs. Taxes that hit business-costs are far worse than taxes that hit profits. Taxes on costs uniquely have the power to drive firms out of business, leading entire markets to shift away from perfect competition (maximum wealth and equality) and towards monopolistic competition (which destroys wealth and concentrates what is left).

By its very accounting, a tax on profits taxes only what remains after expenses have been paid. No matter how high a tax on profits is, it CANNOT INCREASE BUSINESS COSTS. As such, it cannot force a business to cutback production, layoff employees, or go from making a profit to losing money and ultimately going out of business.

A tax on business-costs, however, can do all of this. Increasing a business’ cost of production WILL force it to cutback production, WILL force it to layoff employees, and CAN take a business that is just barely scraping by and put it under. By the very accounting of it, a business with thin profit margins is highly susceptible to being “put under” by a tax on costs. Thin margins mean costs are a very high portion of revenue. A 3% increase in costs will shutdown a business with a 2% profit margin. Conversely, a 95% tax on profits would never shut any business down.

Bigger businesses are better able to survive cost increases, business-cost taxes included. First, they are better able to pass on increased costs to both consumers and workers due to market power. Second, even if they can’t pass on all of the costs and are forced to operate temporarily at a loss, they are better capitalized and therefore better able to “ride out the storm” until their smaller competitors die off and the bigger firms are then able to raise prices. Business-cost taxes are pure poison to competitive markets, consumers, and workers alike. The increased market power of the remaining firms raises prices, lowers wages, reduces supply, and limits choice.

The cost of gas, just like the cost of labor, is a nearly universal business cost. Even a business that buys no gas directly is affected by the increased cost of purchases they make that use gas to get to the store shelf.

Politicians like these types of taxes because, for almost all businesses, costs are much bigger than profits. Politicians are drawing from a larger pool so they can raise the same amount of money with a lower percentage rate than they would need drawing from the smaller pool of profits.

Unless we are willing to reject the entire institution of government, then we must accept some taxation. It is therefore imperative to understand that all taxes most certainly are NOT created equally; some are far more destructive than others, and we must understand how and why some are worse than others. Taxes that directly reduce economic output contribute to less-perfect competition, are highly regressive, and are among the worst.

-- Also at my Seeking Alpha blog --