Taxing Businesses, Encouraging Investment: Running the Numbers

January 29th, 2011

Both Mike Kimel and commenter Jazzbumpa have suggested recently that higher personal tax rates encourage business owners to invest in their businesses — “investment spending” in truly productive fixed capital — as opposed to “investing” the money in financial instruments (IOW, “saving” it). (If you’re not totally clear on “investment” versus “savings,” and versus investment in fixed assets, see here.)

The notion sort of made sense to me — you could avoid being taxed on that income/profit if you put it back into the business (deducting it from taxable profit), so there’s real incentive there, and the higher the tax rate on income from your savings, the more the incentive.

But I needed to run the numbers to see what was really going on. Here are two scenarios.

In both, the business owner has a million dollars in profits in Year 1.

She can either purchase fixed assets for the business, or take the money personally. (If she’s running an S-Corp-elected business, it doesn’t matter whether she distributes them or leaves them as cash in the business; she’s taxed on the profits at personal rates whether she distributes them to herself or not.)


• 20% tax rate on both financial returns and business profits

• Ten-year straight-line depreciation on business fixed assets ($100K/year in this scenario)

• 8% before-tax returns on financial investments

• 15% before-tax returns on fixed-asset investments

In which scenario does she have more money in Year 11?

Invest in fixed assets: $1.24 million

Invest in financial assets: $1.40 million

And the financial investment requires no work on her part. She can just gaze fondly at her bank balance and buy another ticket to Antigua.

Which would you choose?

It seems odd, I know. The financial investment costs $200K in taxes right off the bat, instantly reducing it to $800K, and it only earns 8% compared to 15% for the fixed asset. How could it end up ahead?

Here’s the rub: fixed assets actually do depreciate. Buy a million dollars of laptops for your employees, and ten years from now they’re worth nothing. Yeah, you get to deduct that depreciation from your taxes over the years, but that just means Uncle Sam’s paying part of it — significantly less than 20% in present-value terms.

Our business owner’s financial investment is quite otherwise. In year 11 she’s got ten years of returns from that investment, plus the original million dollars.

So from the perspective of a business owner, fixed-asset investments are — by their very nature — disadvantaged compared to “investments” in financial assets.

Yes: as tax rates go up, the differential between the two investments shrinks. But to make them equal (I goal-seeked it), the tax rate would have to be 104% — she’d need to give Uncle Sam more in taxes than she earns in profits/returns.

Here’s another goal-seek: with everything else the same, if returns on fixed capital were 18% instead of 15%, the two investments would yield equal returns. So in this example annual returns on fixed capital have to be 10% higher than returns on financial capital for the two “investments” to deliver equal returns.

Now assume we want to encourage investments in fixed capital — stuff that actually produces things — instead of financial assets that essentially chase their own (and each other’s) tails, throwing off more financial assets (“money”)  in the process. Can we do that through the tax code? You bet.

If you tax returns on fixed assets (true business profits) at a lower rate than returns on financial assets, you give fixed-asset investments a real advantage. But their native disadvantage is so great that the tax difference has to be big — about 30% in this scenario.

So if taxes on returns to fixed-asset investments are 0%, and taxes on returns to financial assets are 30%, in this scenario it’s pretty much a toss-up which one to invest in. 5% and 35%, same thing.

This gets complicated, of course, because 1. businesses have returns from financial assets, but they’re taxed the same as returns from fixed assets (it’s all “profits”), and 2) Non-S corps (C corps) in theory pay 15% taxes on all profits (whatever their source), and the remaining profits, when distributed as dividends, are taxed again at a reduced personal tax rate for dividends. Further spreadsheeting needed.

But still: this all tells me that if we want to encourage productive business investment in fixed assets, we should tax businesses’ returns on financial assets at a much higher rate than the rest of their profits. Ditto for personal returns on financial assets.

Since this post is getting long, I will leave it to my gentle readers to ponder all the salutary effects such a tax regime would deliver.

  1. January 29th, 2011 at 14:26 | #1

    I agree with your assessment, as far as it goes, and most especially your conclusion at the end.

    However, you left something out of the analysis that will change things quite a bit in favor of investing in the business: growth.

    What you have done is valid for a stagnant cash cow, or perhaps simple replacement of an article at the end of its useful life, but not for a growing business, like Mike’s, where the growth should compound.

    Suppose that investment is not in a depreciating (in the utility rather than financial sense) asset, like a computer, but in a real productive asset that generates income: production machinery, medical equipment or another gung-ho employee (I know – expense vs investment, but it’s still a cash outlay that generates more profit for the business.)

    I’ll be like the AB trolls and ask you to run the numbers again with this new parameter included.


  2. January 29th, 2011 at 15:28 | #2

    @jazzbumpa I don’t really understand how compounding would work in this model. I have it set up so returns from fixed-asset investments are added to cash, earning compounding financial returns in ensuing years — rather than being used to purchase new fixed assets.

    This could be a thriving, growing business. I just abstracted out one year’s decision by a business owner — re-invest, or take the money and run?

    All those physical items you mention both decay and become obsolete (different things, and accounted for differently in the NIPAs btw). As for knowledge/skills from training (also a “fixed asset,” though not counted as such in the NIPAs), employees move on, die, etc. You can tweak your depreciation schedules, but the reality of fixed-asset value decay is inevitable.

  3. January 29th, 2011 at 16:24 | #3

    After I posted, I wondered if I was off in a cocked hat, since you were compounding the investment value at 15%.

    Anyway, you’re looking at an accumulated difference of $160K in the 11th year, with a lot of iffy assumptions. Where are you going to get an 8% return these days? That $160K isn’t decimal dust, but it’s highly uncertain – should it really throw the decision toward a financial “investment” rather than a real investment?

    And is this the real decision? Profits pulled from the business are more likely to be spent on a vacation in the Bahamas or a new BMW than allocated to a lucrative financial asset. That was Mike’s point, I think.

    I’ll shut up now.


  4. February 2nd, 2011 at 01:31 | #4

    Does this take into account the possible increase in yearly profits a small business may see by investing in fixed assets? Things like a larger store, advertising, hiring more employees, etc.
    I know this post takes into account the different tax rates on fixed versus financial investments, but I believe there are many intangibles, as well.

  5. February 2nd, 2011 at 08:55 | #5

    SavageMike :

    Does this take into account the possible increase in yearly profits a small business may see by investing in fixed assets?

    Yeah; I assumed that investment in business fixed assets yielded 15% (or 18%) return, compared to 8% for financial assets.

    The exact numbers aren’t so much the point, though. Rather, that fixed assets are inherently disadvantaged compared to financial assets in the competition for investment, because fixed assets 1. decay physically and 2. become obsolete (these are accounted for differently in the NIPAs), while financial assets don’t.

    This by itself is not a normative statement; just a fact.

    But I will make reiterate my normative statement based on that fact: in our tax system we should reward investments in fixed assets over investments in financial assets by, for instance, not taxing real profits (roughly, returns on fixed assets), but taxing returns on financial assets (at least by businesses) at a much higher rate.

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