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Monday, February 21, 2011

The Poker Rules For Businesses

I found your comments on the last post really interesting.

The first thing I wanted to address would be the topic of business taxation (and capital gains) - one of the topics that came up was business taxation, and that lower taxation might not create jobs. That's both true and untrue. In general, cutting marginal tax rates does tend to create jobs, but I would be highly suspicious of our current system of specialized tax breaks combined with high marginal tax rates.

It's like poker. A good poker player knows the odds of winning with the hand she's got. But in each successive decision in a hand, it's not just the odds but the money that is in the pot and the investment required to get the chance of winning along that underlie the decision to stay in or get out.

An example:
You have a hand that gives you a 1 in 4 chance of winning. There are eight dollars in the pot. You have to pay three dollars to stay in. If you did this four times, you'd win eight dollars (on average) and you'd have paid 12 dollars for the privilege. Not a good business plan!

But suppose you have the same hand that gives you a 1 in 4 chance of winning. Once again, there are eight dollars in the pot. This time, you only have to pay one dollar to stay in. If you did this four times, you'd win eight dollars (on average) and you'd have paid four dollars for the privilege. A very good business plan - provided you have the necessary stake (capital) to keep playing. That's what poker is about.

Business works very similarly. Businesses are constantly trying to decide whether to invest more money, not invest but continue in business, or whether to fold (stop putting in money and shut down the business). The odds they calculate are based on their knowledge of their business fundamentals and the external economy. However marginal tax rates determine how much money is in the pot, which changes the amount of investment the business will consider. Businesses' assessments of uncertainty also vary over time with the economic climate, which may change their calculation of rates of future return on investments. And then there's tax policy.

Higher marginal tax rates are particularly effective in suppressing business investment and job creation in higher risk environments, and even more so when a lot of capital has to be invested to produce the jobs. They reduce the size of the pot. Suppose in the examples given above the house took 50% of the pot. In the first example, our poker player would now be paying $12 for a return of $4. In the second example, our poker player would be paying $4 for a return of $4.

An example:
You have a packaging business. Your business has emerged from the depths of the recent downturn with about a 20% increase in business and is making some profit again. You have no loans. However your machinery is not that flexible, and orders aren't picking up that much more. After beating the bushes for business, you find that you can definitely get considerably more orders if you can package much more flexibly with smaller sizes, due to the needs of consumer companies to keep their units of sale below certain price levels (i.e., there is a much bigger demand for 10 ounce packages that used to contain 12 ounces).

Now you are faced with a decision. You can spend 500K to upgrade your machinery net installed, but tax law will require you to amortize that cost over 10 years. You almost certain that you can get enough new orders with the new equipment to net you an extra 100K in before tax profits each year over the next two years. You might net 125K after the first year. You suspect that you are going to be paying more for utilities over the next decade, so you are not sure about maintaining your profit margin after that. But you think that you will be able to continue to expand your business at least somewhat in the next five years, unless there is another significant downturn.

You don't have the 500K. You have about 100K in your capital fund. The company offers a lease deal over 7 years, with option to buy, but it is effectively going to cost you 10%. You can get a loan from the bank with a lot of irritating paperwork and covenants for 75K down (borrowing 425K) at 5% going variable after 2 years to 1% plus prime rate. Plus it's a UCC everything, meaning that if you don't pay, the bank can seize and sell all your equipment plus all your business accounts. And the covenants are sure irritating, you have to give the bank quarterly financial statements plus updated lists of frigging assets as long as you have the loan. Yuck.

Your interest is going to be deductible from profits, and for the first year it is about 21K. Your annual loan payment is about 54K. Simplifying, let's assume that you are allowed to deduct the capital cost of the equipment equally over 10 years. That's 50K a year. You deduct interest on the loan. Your marginal net income tax on the extra income (state, federal, local) is at 46.9% (see federal & WI). So 100K - 21K - 50K = 29K * 7.9% WI = $2,291. Federal = 39% * (29K - 2.3K) = $10,416. Extra taxes of $12,707.51.

So your first year cash flow is 100K (extra gross profit) - 54K (loan) - 12.7K (taxes) = 33.3K. That's not great. You have to replenish your working capital, and it looks like it will take you close to 3 years to do that. The tax bite will increase in later years as your deducted interest drops. This is a very questionable move. Yes, you may make the extra 25K in gross profit in the second year, but that only nets you another 15K. You've assumed a lot of risk and fixed expense with that loan.

This is one reason why administrations usually put in expensing of equipment during and right after a recession - the ability to expense equipment creates a lot of new investment. (Expensing equipment allows you to deduct the total cost in the year you buy it, or more of the cost.) It crashes corporate taxes, although it does tend to keep up personal taxes.

The tax rates I cite are accurate. US federal corporate tax policy is lunacy squared. For profits between 75-100K, it's 34%, then for 100K-335K it's 39%, then it goes down to 34% for 335-10 mil, then up to 35% for 10-15 mil, then to 38% for 10-18.3 mil, then down to 35% for over 18.3 million. You can also choose to be taxed as a pass-through in many cases, which would net you lower taxes in some cases. And federal corporate income is reduced by state and local corporate taxes (in the US, the state and local tax adds up to over 16% in some places), so in effect we subsidize states. But then, we also tax all income of domestic corporations no matter where it is earned, although we give a credit for taxes paid elsewhere. Most countries only tax domestic income. More info.

Capital gains taxes are yet another football. In a lot of ways, capital gains taxes are a tax on inflation. Just as eliminating the capital gains exclusion for the first 500K of a person's primary residence would cause many persons to take a net loss if they bought a house, paid it off, and then sold it to move into a retirement home in their later years, corporations are also forced to engage in many bizarre transactions solely for tax reasons.

Because pass-through taxation rates are often lower on net, a great number of businesses elected to go pass-through. And that means that we now cannot raise personal income tax rates very much without really hurting business investment and job creation.

And now, Sporkfed, listen up. Because I know you just don't want to hear this:

This guy in the packaging business? He has about 50% chance of surviving the next seven years if he does this. If he is in his later 50s, he shouldn't do this. Because if we even have a downturn in 2013, much less a real recession, he probably won't be able to make that loan in 2014. And when he doesn't, his banker essentially owns his entire business. Everything the guy has worked for he loses.

No, what Packaging Guy, who, given demographics, is likely in his 50s, SHOULD DO is tighten this thing up, conserve cash, and pretty up his balance sheet. And then he should look to sell out in the next couple of years. And by "tighten up" I mean cut employee costs, and not put ANY money into the business that doesn't pay back within two years.

And if you look at what businesses are doing, that's precisely what is happening. Because margins are declining, uncertainties are mounting, and the reality is that many business owners are nearing retirement and shouldn't be taking risks of getting cleaned out. The more capital you would have to put in (the higher the bet), the greater the uncertainties.

Look at what Packaging Guy is really facing. He's got employees. To really make his buck back on the new investment, he needs to expand hard, and that means he has to hire new employees. And with the health care reform, that may be terribly costly. It's an uncertainty for businesses who have 20-40 employees, that's for sure. A rise in general tax rates is almost certain, given the fiscal problems. His power costs are going to go up. If he's in WI, his heating costs are going to go up. Insurance costs per employee are going to go up. There are going to be all sorts of little state and local fees and goodies and licenses and audits. And then there's regulations. Lord, the regulations. The larger the business gets, the more regulation, and oh, the joy of potentially running into new CO2 standards. Face it. Mr. Packaging Guy ain't gonna decide to be a Real American Hero and expand.

If, through tax policy, we change the equation enough, Mr. Packaging Guy might. But note that the expensing provisions, for example, really help the larger corporations more. They get a much higher net payback on average because they have more profits! The worst of it is that our current policies really favor expansion in larger corporations, but the larger the corporation, the more likely it will choose to funnel some of the returns overseas in better business environments.

Practically all the "socialist" European countries have gone to a low corporate income tax rate with much higher personal income taxes. Try this. They have done so to create jobs. Check into Finland and Sweden and Denmark and Austria and China and France and Germany. And think. Think HARD. Spain's corporate income tax is 30%, but there is a special low, low recession rate right now of 20% for some small companies. The world changed, and we did not change with it. Australia's at 30%.

This is Wisconsin's labor and employment data at BLS. How do these graphs look to you?

Part of WI's problem is that its population is a couple of years older than the US population, so it will hit the retirement hump more quickly.

This is somewhat apparent in the labor force stats. The labor force graph is almost flat from 2003 if you ignore the recession hump.

But clearly, the drop in jobs since 2003 means that a lot of jobs must be created to get back to par. Since December 2003, the percentage of non-farm workers employed by government has risen from 14.77% to 15.65%.

Government workers were 411.0 in December 2003 vs 427.3 in December 2010.

One of the things Wisconsin must do is to increase its private jobs. Over the course of the last "recovery" six months, total non-farm employment rose from 2728.8 to 2731.0, but government jobs rose from 422.6 to 427..3. In other words, non-farm private employment dropped. WI can't keep going like this.

People are talking about our current problems with all sorts of rhetoric, but very few are dealing with the mathematical problems. Talk about justice and fairness and sharing and sacrifice won't get you anywhere if the numbers aren't there.

All I need to know about business I learned on MaxedOutMama.

Outstanding article! For those that read it and understand, they can probably now skip business school.
The post is very intellectually written, with lots of valuable information.
I was doing a little free computer work for a friend of mine who has a small woodworking business. He is on the edge of bankruptcy. But, his employees only see the checks coming in. They do not see the cost o materials and the cost of keeping the doors open. So, they have a very skewed view of how the business is doing are quite surprised when they are laid off.

No one ever talked about opening your own business when we were in high school. But, I believe we are going to see a lot more self employments. It is not so risky if you are basically selling your own labor, but if you have to create an infrastructure like the packaging business or a woodworking shop, the fixed costs add up quickly and the risks of expansion are high.

One of the major takeaways from your post is we reduce the final rewards from risk and increase the costs of risk. I look at the central valley of California. Here is one of the breadbaskets of the US that is now drying up because we thought, when we were a richer country, it was a good bargain to protect a small fish. It turns out the human and economic costs of that decision overwhelms any value that may be returned. That type of destuction is being replicated across the country. There is no evaluation of the cost vs the benefit of our regulations. We also have an administration that is trying to pile cost after regulatory cost on businesses and then complains about the lack of job creation. We need to give everyone in the EPA a copy of your poker rules to put this all into perspective.
I don't disagree with your post but it's not just
taxes and regulations that are making it harder
for small and medium businesses. Cheaper competition from foreign countries for him and his customers ? It's not just labor that suffers from free trade but small and medium businesses and that's where most job creation comes from. It's not just a spending problem but a revenue problem and cutting business taxes will not solve the deficit. Tariffs would go a long way towards solving the budget problems faced by both the Federal government and the states while reducing the tax burden on individuals and businesses.
How many tax breaks did GE or Boeing get and how many jobs did they ship overseas in the last decade ?

Spork - with any luck, Neil will show up to back me up, but still, I think Mr. Packaging Guy kind of makes the point.

First, to some extent the tougher competition is just there. The way US businesses can offset is through more flexible manufacturing with higher capital investments.

For a lot of packaging, it doesn't make sense to ship cheap stuff overseas, process it, and then ship it back. I'm thinking Mr. Packaging Guy is in the food/consumer commodities business, and a lot of food is produced here.

What I'm trying to show is that Mr. Packaging Guy has a tough environment in which to expand regardless.

Then there are material costs. For example, it seems to me that India and China often try to go vertical by controlling input prices of commodities that are domestically produced. So maybe the steel an Indian corporation can buy is considerably cheaper than the steel a US mfr would get.

It's not that I think tariffs are always wrong - we can go right back to Adam Smith and see that free trade only makes sense if it really is free - but that I don't think that tariffs are going to bring it back.

In many cases, production costs are really lower in the US, especially for smaller order, lower run, flex mf types of stuff. The crap you get from overseas often chops up all your contractual profits. But when you throw in the regulations and other overhead, the uncertainties are such that people just don't want to invest the $$ in the US.

I totally agree with you about our tax policies being negative toward small business and skewed toward large businesses that do export jobs and probably will continue to do so.
Sporkfed keeps coming back to tariffs as an answer to almost every problem. But, once we get past the word "tariff", we need to understand what and how. First, we import many of our commodities. Are we going to put tariffs on things like oil and rare earths? I think not even Sporkfed would go so far. But, if we did, those tariffs would raise the cost of production and transportation by at least the amount of the tariff.

I finally bought a physical copy of Hazlitt's "Economics in One Lesson" rather than trying to read it as a pdf. Chapter 11 talks about tariffs and points out tariffs raise the price of goods, hence reducing the number of goods people can buy for their money. The net is a lower standard of living. Our objective should be to lower the cost of production of goods via reduced regulations and increased productivity, not to increase the cost of goods. If we imposed Sporkfed's tariffs, Walmart would have had an even more dismal quarter than they did.

To address the "jobs shipped overseas" argument, I go back to Intel. Intel says it would cost an additional $1 billion to build a new plant in the US rather than in Asia. That, to Intel, is an insurmountable gap. That is why I keep arguing we are doing all this to ourselves. We don't want another Love Canal, but we also do not want farmers afraid to plant too close to drainage ditches either.

The tax breaks for GE and others are more due to political influence (read that "donations") than economics.
I thought Intel just announced they are building a new plant in AZ? Or did they say that just to suck up to Obama while he was here?
I have stated before that tariffs should be onanufactured
Goods not vital raw goods like oil. I live in
A town that has been decimated by "free
trade". Not everyone can have or perform
a knowledge job. Now, has anybody looked
to see who is benefitting from Gov. Walker's
Corporate tax breaks ? They aren't shared

Cutting taxes creates jobs?

Some thoughts:

1, DEMAND is the key.

2. Business today is volume driven job shops based around skilled labor is long gone. The issue is always the same, large capital investment required! Tax policy drives business towards capital intensive purchases which gains quick write offs with added bonus for generous interest write offs. Net results is higher productivity but lower employment gains then past business investment cycles.

3. Small business needs higher margin sales to survive since they tend to be lower volume unless they can gain access to distribution/sales channels that quickly generate higher volumes but that takes larger and larger capital investment either to fund equipment expansion or staff up. One can lose it all very quickly by over committing to new equipment (changing technology) or lose valuable distribution space to competitors with greater capital resources which is why social networking or government sponsored green tech tends to be in play these days.

4. Glad I am retired and watching on the sidelines
Teri, Intel is not a small to medium sized business.


"The state-of-the-art plant, which will crank out microchips with next-generation 14 nanometer line-widths, is expected to bring thousands of jobs to the cash-strapped western U.S. state, which is offering more incentives to lure businesses.

The announcement came after the White House announced it had appointed Intel Chief Executive Paul Otellini to a panel of experts advising U.S. President Barack Obama on jobs."

So it's no different than a political favor to GE. An economy becomes based on political favors is not an economy at all.
I have stated before that tariffs should be onanufactured
Goods not vital raw goods like oil.

What you say doesn't matter because you can't control what another country's retaliatory tariff on YOUR items is going to be.

If you want the US to be self-sufficient, then just say so. But realize we can't be self-sufficient without imported oil and at our present regulatory rate we are importing an ever-growing percentage of our gasoline too. In other words, you can't look at tariffs and completely ignore other internal regulations, they don't exist in separate vacuums.
This is pure gold! Thanks, MOM. Also a lot of excellent comments. Econ for those who want to grasp how things are/are not working these days.

For what it's worth, I think M_O_M's packaging business shows how a marginal business responds to taxes and regulation. I've never been in quite that marginal a situation, but I can imagine it pretty clearly. It's the marginal decisions like M_O_M's packaging company that change the numbers--if there's enough of them and they make enough positive decisions then you get big improvements. Relatively small changes in the tax code can make big changes in investment and employment.

But here's the more important factor: Sporkfed, I mostly agree with your analysis of the situation. If jobs and the balance of trade are the sole criteria, then tariffs make a great deal of sense. I just think there's some externalities that become more important than simple economics in a global system where the U.S. raises tariffs to protect its regulatory and tax inefficiencies.

First of all, it allows our economy to be less efficient, producing fewer goods and fewer dollars per labor-hour, leading to a lower per-capita income (and probably the median income as well). Honestly, this would be enough by itself to make me look for other solutions but it's reasonable to think reduced inequality might make up for lower per-capita income. The bigger problem is that this reduces, among other things, our material ability to field 11 aircraft carriers and a large mobile army.

Second, right now we are essentially bribing the world's nations to remain relatively peaceful competitors, by keeping the world open to trade. Those 11 aircraft carriers are the world's cops on the beat. A lot of people say that's arrogant, or stupid. Maybe it is, but it also keeps the peace.

But our carriers are only sufficient to do the job because nobody really wants to give up trading with the U.S. If we go protectionist then the system of global trade breaks down, and countries go back to competing militarily. We're in for 80 years of warfare at that point, because if the U.S. withdraws there's no clear big boy anywhere. I think we would rapidly get used to the idea of limited-exchange nuclear engagements.

That's the real reason I think it's so important to make our tax and regulatory regimes more efficient, rather than preserving the inefficiencies by raising tariffs.

I had not seen the Intel announcement. I was going with a statement like this:

"A new manufacturing plant for state-of-the-art microprocessors can cost $5 billion in the U.S. or $3 billion in a lower cost Asian site, which makes offshore manufacturing by U.S. companies very attractive, even with added support requirements. As a result, substantial infrastructures have been established in many countries for even the most complex procedures."

Walter Russel Mead has an essay today that is directly on point. It is almost as if he and M_O_M are collaborating:

Rick, you honestly think Intel got no tax breaks? Of course they did. There won't be any spending decrease of course, so smaller business will be taxed higher to make up the difference.

We have structural tax problems in the US and we do nothing to address it except on a case-by-case basis, the most inefficient and ineffective way to address it.
I don't agree with some of Sonoma Potter's points.

1. The first point "DEMAND" is correct. If nobody wants your product, then you will not be successful. If we go back and look at the dot com bubble, there were a lot of solutions in search of a problem.

2. High volume is not always a solution. High volume implies low costs and low margins. As I recall when the US steel industry almost died, it was not the high volume guys who survived. It was the specialty steel companies. Flexibility (to go back to the original post) matters. High volume woodworking is particle board with veneer. High quality woodworking is solid cherry and mahogany. I have never been a believer in the "grow or die" business philosophy. Too many companies have grown themselves right into bankruptcy.

3, Often, small business has lower overhead/ fixed costs than the big boys. So, they try to leverage that with customer service and smaller jobs. They look for higher margin business.
Business is more like the old fashioned yo-yo. There are many ups and downs!
By the way M_O_M, the generational point you make with your packaging-company owner is a good one. I hadn't thought about that in relation to business ownership. (Sigh) one more thing to worry about.
@Charles Kiting

Sorry if I left the impression Intel did not get any tax breaks. I was simply quoting an article that said it costs substantially more to build a chip plant in the US vs Asia.

I was making no comment at all about tax breaks.
I know Intel is not a small business (I used to work at Netflix in Hillsboro, which is just down the road from the Intel campus.) I was responding to the post about building plants overseas versus building in the US.
Raw data and common sense hardly ever figure into government programs. Everything our government touches turns into a loser.
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