Taxation Thought Experiment

Another thought experiment, comments welcomed:

o TAXES THOUGHT EXPERIMENT

 1) I generate $100 of productivity for my company
 2) Company is taxed %30, $70 left
 3) Company pay shareholders and costs, $30 is left
 4) Company pays me
 5) I pay 40% in taxes, so $18 left
 6) With $18 I can buy a $16.82 object (%07 sales tax).

Results:
 1) I see $16.82 realization from $100 productivity increase.
 * Govt. gets $49.26 of my productivity, or nearly 3 times the amount I get.
_______________________
Regards,          Our greatest glory is not in never failing, but in rising 
                  up every time we fail.  -Ralph Waldo Emerson
Joseph Reagle     http://rpcp.mit.edu/~reagle/home.html
reagle@mit.edu    E0 D5 B2 05 B6 12 DA 65  BE 4D E3 C1 6A 66 25 4E

I think there's some funny accounting here...

On Tue, 12 Nov 1996, Joseph M. Reagle Jr., for whom I have considerable
respect and who ordinarily posts very sensible things but appears to have
lent his account to someone else appeared to have written: 

> o TAXES THOUGHT EXPERIMENT
> 
>  1) I generate $100 of productivity for my company

I will assume you measure productivity by "sales". 

Note also that it's debatable whether this $100 of sales is exactly "your" 
productivity.  In some sense it's really the company's, ie a joint product
of your labor, their capital, and the labor of other people in the
production/sales chain: If you could do it alone, you would, so as to
capture the full benefit yourself.  That is why economists sometimes
measure labor productivity by "salary" on the theory that the market
accurately measures what your output is worth.  

Note also that the analysis that follows is not really affected by whether
you meant "sales"  or "my contribution to the sale". 

>  2) Company is taxed %30, $70 left

No.  Company is NOT taxed on gross sales. Corporate income tax does not
work like sales tax.  With some minor exceptions relating to pass-through
rules, foreign sales, and some complex timing issues, corporate tax is
ordinarily levied on NET PROFITS.  Thus, the company first deducts all the
"costs" it can identify, even if those were not necessarily involved in
producing that (or any) sales.  E.g.  advertising, your salary, corporate
junkets, rent, etc.  And lets not forget corporate tax sheltering too... 

>  3) Company pay shareholders and costs, $30 is left

Again, no.  Shareholders come AFTER payroll and costs.

>  4) Company pays me

See above.

>  5) I pay 40% in taxes, so $18 left

I'm afraid you are conflating the MARGINAL rate (and when you consider
federal, state and local taxes varies by state) with the AVERAGE rate.
Here in FL. for example there is no state or local income tax.  With tax
sheltering, mortgage deductions etc. no one pays 40% -- the middle class
pay a lower average rate, the upper class pay a much lower average rate.

>  6) With $18 I can buy a $16.82 object (%07 sales tax).

By now we are into science fiction.

> 
> Results:
>  1) I see $16.82 realization from $100 productivity increase.
>  * Govt. gets $49.26 of my productivity, or nearly 3 times the amount I get.

Totally skewed, sorry.  I don't know what the real numbers are, but the
government gets *much* less than this.  I'm sure the aggregate numbers can
be found in the statistical abstract of the U.S. or the council of
economic advisors' annual report to the president, neither of which
happens to be in my office right now.

A. Michael Froomkin        | +1 (305) 284-4285; +1 (305) 284-6506 (fax)
Associate Professor of Law |
U. Miami School of Law     | froomkin@law.miami.edu
P.O. Box 248087            | http://www.law.miami.edu/~froomkin
Coral Gables, FL 33124 USA | It's warm here.

"Michael Froomkin - U.Miami School of Law" <froomkin@law.miami.edu> writes:

> I think there's some funny accounting here...

Creative accounting is the name of the game. Pay attention, IRS...

> On Tue, 12 Nov 1996, Joseph M. Reagle Jr., for whom I have considerable
> respect and who ordinarily posts very sensible things but appears to have
> lent his account to someone else appeared to have written:

Another one of John Gilmore's electronic forgeries and fabrications (EFF)?

> > o TAXES THOUGHT EXPERIMENT
> >
> >  1) I generate $100 of productivity for my company
>
> I will assume you measure productivity by "sales".

No, I think he understands that the cost of good sold and other costs are
taken out of "sales" to compute his contribution.

> Note also that it's debatable whether this $100 of sales is exactly "your"
> productivity.  In some sense it's really the company's, ie a joint product
> of your labor, their capital, and the labor of other people in the
> production/sales chain:

And of course you use the infrastructure paid for with your taxes and
other people's taxes (state and federal).

> Note also that the analysis that follows is not really affected by whether
> you meant "sales"  or "my contribution to the sale".
>
> >  2) Company is taxed %30, $70 left
>
> No.  Company is NOT taxed on gross sales. Corporate income tax does not
> work like sales tax.  With some minor exceptions relating to pass-through
> rules, foreign sales, and some complex timing issues, corporate tax is
> ordinarily levied on NET PROFITS.  Thus, the company first deducts all the
> "costs" it can identify, even if those were not necessarily involved in
> producing that (or any) sales.  E.g.  advertising, your salary, corporate
> junkets, rent, etc.  And lets not forget corporate tax sheltering too...

In Germany, a company can put practicially inlimited amounts of money into
tax-deductible reserves. E.g., you can estimate that once in ten years you'll
be unable to collect a debt of 10DEM. Every year you set aside 1DEM as a sort
of self-insurance reserve. The revenue authorites don't bother you if the
assumption of 10DEM every 10 years is overly pessimistic. Therefore German
corporations generally pay little income tax.

> >  3) Company pay shareholders and costs, $30 is left
>
> Again, no.  Shareholders come AFTER payroll and costs.

Dividends are NOT tax-deductible in the U.S. On the other hand, interest is.
Therefore it's sometimes more profitable for a company to raise money by
issuing bonds (debt) and paying tax-deducuble interest than by selling its
stock (equity) and paying non-decuctible dividentds to stockholders.

> >  5) I pay 40% in taxes, so $18 left
>
> I'm afraid you are conflating the MARGINAL rate (and when you consider
> federal, state and local taxes varies by state) with the AVERAGE rate.
> Here in FL. for example there is no state or local income tax.  With tax
> sheltering, mortgage deductions etc. no one pays 40% -- the middle class
> pay a lower average rate, the upper class pay a much lower average rate.

That varies with the locale - here I pay the federal income tax plus the New
York State income tax plus the New York City income tax. I once had a job offer
from IBM at $79K/year in Boca Raton (which I eventually didn't take anyway) -
it's a ridiculous salary in NYC, but a decent one in Florida.

---

Dr.Dimitri Vulis KOTM
Brighton Beach Boardwalk BBS, Forest Hills, N.Y.: +1-718-261-2013, 14.4Kbps

Dr.Dimitri Vulis KOTM wrote:
> > >  3) Company pay shareholders and costs, $30 is left
> >
> > Again, no.  Shareholders come AFTER payroll and costs.
> 
> Dividends are NOT tax-deductible in the U.S. On the other hand, interest is.
> Therefore it's sometimes more profitable for a company to raise money by
> issuing bonds (debt) and paying tax-deducuble interest than by selling its
> stock (equity) and paying non-decuctible dividentds to stockholders.

This statement is very questionable. Various classes of shareholders
(such as pension funds and IRA account holders, among others) pay no 
taxes on dividends. Corporations pay taxes only from about 30% of
dividend income that they receive.

There is, in fact, a neat theorem that says that (*_under certain 
assumptions_*) the value of a firm does not depend on its capital
structure.

> > >  5) I pay 40% in taxes, so $18 left
> >
> > I'm afraid you are conflating the MARGINAL rate (and when you consider
> > federal, state and local taxes varies by state) with the AVERAGE rate.
> > Here in FL. for example there is no state or local income tax.  With tax
> > sheltering, mortgage deductions etc. no one pays 40% -- the middle class
> > pay a lower average rate, the upper class pay a much lower average rate.
> 
> That varies with the locale - here I pay the federal income tax plus the New
> York State income tax plus the New York City income tax. I once had a job offer
> from IBM at $79K/year in Boca Raton (which I eventually didn't take anyway) -
> it's a ridiculous salary in NYC, but a decent one in Florida.

You forget about alligators.

	- Igor.

ichudov@algebra.com (Igor "FUCK MNE HARDER" Chudov @ home) writes:
> Dr.Dimitri Vulis KOTM wrote:
> > > >  3) Company pay shareholders and costs, $30 is left
> > >
> > > Again, no.  Shareholders come AFTER payroll and costs.
> >
> > Dividends are NOT tax-deductible in the U.S. On the other hand, interest is
> > Therefore it's sometimes more profitable for a company to raise money by
> > issuing bonds (debt) and paying tax-deducuble interest than by selling its
> > stock (equity) and paying non-decuctible dividentds to stockholders.
>
> This statement is very questionable. Various classes of shareholders
> (such as pension funds and IRA account holders, among others) pay no
> taxes on dividends. Corporations pay taxes only from about 30% of
> dividend income that they receive.

Igor, you begin to sound like an American - i.e., even more stupid than the
50%sovok that you are.

I never said anything about the taxes paid by the dividend _recepients.

> There is, in fact, a neat theorem that says that (*_under certain
> assumptions_*) the value of a firm does not depend on its capital
> structure.

Igor, you begin to sound just like Timmy May - talking about things you know
nothing about. Yes, there's a famous theorem by Franco Modigliani and Merton
Miller, the Nobel prize winners which says that ABSENT TAXES, the value of the
firm doesn't depend on its debt-to-equity ratio. M&M also show that under U.S.
tax laws the best capital structure is 100% debt (again, ignoring other
available deductions, such as depreciation, and increased risk and cost of
borrowing as the debt increases).

"The value of the levered firm is the value of the levered firm plus the
interest tax shield (the amount of debt times the tax rate)."

Companies would borrow less (and people would take out mortgages on their
residences less) if the interest payments weren't tax-deductible.

> > > >  5) I pay 40% in taxes, so $18 left
> > >
> > > I'm afraid you are conflating the MARGINAL rate (and when you consider
> > > federal, state and local taxes varies by state) with the AVERAGE rate.
> > > Here in FL. for example there is no state or local income tax.  With tax
> > > sheltering, mortgage deductions etc. no one pays 40% -- the middle class
> > > pay a lower average rate, the upper class pay a much lower average rate.
> >
> > That varies with the locale - here I pay the federal income tax plus the Ne
> > York State income tax plus the New York City income tax. I once had a job o
> > from IBM at $79K/year in Boca Raton (which I eventually didn't take anyway)
> > it's a ridiculous salary in NYC, but a decent one in Florida.
>
> You forget about alligators.

And sharks.

---

Dr.Dimitri Vulis KOTM
Brighton Beach Boardwalk BBS, Forest Hills, N.Y.: +1-718-261-2013, 14.4Kbps

Oops:

dlv@bwalk.dm.com (Dr.Dimitri Vulis KOTM) writes:

> "The value of the levered firm is the value of the levered firm plus the
                                                     ^un
> interest tax shield (the amount of debt times the tax rate)."


---

Dr.Dimitri Vulis KOTM
Brighton Beach Boardwalk BBS, Forest Hills, N.Y.: +1-718-261-2013, 14.4Kbps

Dr.Dimitri Vulis KOTM wrote:
> ichudov@algebra.com (Igor "FUCK MNE HARDER" Chudov @ home) writes:
> > Dr.Dimitri Vulis KOTM wrote:
> > > Therefore it's sometimes more profitable for a company to raise money by
> > > issuing bonds (debt) and paying tax-deducuble interest than by selling its
> > > stock (equity) and paying non-decuctible dividentds to stockholders.
> > There is, in fact, a neat theorem that says that (*_under certain
> > assumptions_*) the value of a firm does not depend on its capital
> > structure.
> 
> Igor, you begin to sound just like Timmy May - talking about things you know
> nothing about. 

Surely I know nothing about finance. Never claimed otherwise.

> Yes, there's a famous theorem by Franco Modigliani and Merton
> Miller, the Nobel prize winners which says that ABSENT TAXES, the value of the
> firm doesn't depend on its debt-to-equity ratio. M&M also show that under U.S.
> tax laws the best capital structure is 100% debt (again, ignoring other
> available deductions, such as depreciation, and increased risk and cost of
> borrowing as the debt increases).

See below.
 
> "The value of the levered firm is the value of the levered firm plus the
> interest tax shield (the amount of debt times the tax rate)."
> 
> Companies would borrow less (and people would take out mortgages on their
> residences less) if the interest payments weren't tax-deductible.

See, for example, Merton H. Miller, "Debt and Taxes", American Finance
Assn., Vol. XXXII, May 1977, No. 2. 

Page 262: ``... They conclude that the balancing of these bankruptcy costs
against the tax gains of debt finance gives rise to an optimal capital
structure, just as the traditional view has always maintained, though
for somewhat different reasons. 

It is this new and currently fashionable version of the optimal
capital structure that I propose to challenge here. I will argue that 
even in a world in which interest payments are fully deductible in
computing corporate income taxes, the value of the firm, in equilibrium,
will still be independent of its capital structure.''

	- Igor.

ichudov@algebra.com (Igor Chudov @ home) writes:
> Dr.Dimitri Vulis KOTM wrote:
> > ichudov@algebra.com (Igor "FUCK MNE HARDER" Chudov @ home) writes:
> > > Dr.Dimitri Vulis KOTM wrote:
> > > > Therefore it's sometimes more profitable for a company to raise money b
> > > > issuing bonds (debt) and paying tax-deducuble interest than by selling
> > > > stock (equity) and paying non-decuctible dividentds to stockholders.
> > > There is, in fact, a neat theorem that says that (*_under certain
> > > assumptions_*) the value of a firm does not depend on its capital
> > > structure.
> >
> > Igor, you begin to sound just like Timmy May - talking about things you kno
> > nothing about.
>
> Surely I know nothing about finance. Never claimed otherwise.

Then I suggest that you get hold of an undergraduate book on corporate finance,
such as Ross, Westerfield, Jordan, from Irwin. They just came out with the 3rd
edition). Read their very lucid explanation of M&M's work, and in particular
what they mean by "bankrupcy costs". Sure beats quoting academic papers that
you don't understand.

---

Dr.Dimitri Vulis KOTM
Brighton Beach Boardwalk BBS, Forest Hills, N.Y.: +1-718-261-2013, 14.4Kbps

At 3:25 PM -0500 11/12/96, Joseph M. Reagle Jr. wrote:
>Another thought experiment, comments welcomed:
>
>o TAXES THOUGHT EXPERIMENT
>
> 1) I generate $100 of productivity for my company
> 2) Company is taxed %30, $70 left
> 3) Company pay shareholders and costs, $30 is left
> 4) Company pays me
> 5) I pay 40% in taxes, so $18 left
> 6) With $18 I can buy a $16.82 object (%07 sales tax).
>
>Results:
> 1) I see $16.82 realization from $100 productivity increase.
> * Govt. gets $49.26 of my productivity, or nearly 3 times the amount I get.

Indeed, this is one of several ways of looking at the sickness that faces
us with taxes.

Here's a variant of direct interest to me:

1. Some friends of mine have a good idea for a product and wish to form a
venture to develop it.

2. I sell $200,000 of some asset I own.

3. Tax collectors take 40% of this, leaving me with $120,000 to invest in
the startup venture.

4. There's a high probablility the investment will fail ("venture"
capital). If it fails, and my money has been tied up for several years, I
have not only paid a lot of taxes, but also have lost a normal return. And
my losses, at liquidation, are deductible only against other capital gains.
If I happened to have no other capital gains, I am largely screwed (there
are a few provisions for tax-loss carryforwards, blah blah, but basically
the tax laws are set up to make sure all gains are taxed and make sure
losses are as hard to deduct as possible).

5. In the event that my friends basically succeed, here's the tax situation:

- They owe corporate income taxes of between 35 and 50%, depending.

- Their salaries have been taxed, at rates of 30-45%, typically.

- Any net appreciation in stock value is taxed upon sale at 40%, roughly.

6. It doesn't take a racket scientist to see that investing in a new
business is  increasingly a losing proposition. Add up all the taxes,
factor in the risks, and the answer is clear: why bother?

The crypto-relevance is via crypto anarchy: we need to undermine the tax
system enough that _everyone_, not just us, loses faith in it. (There could
be a "straw that broke the camel's back" effect, if people lose confidence
in the system. Even if most people are _not_ using anonymous digital cash
to hide income, if _enough_ are (and this "enough" could be a visible
minority, visible through recounts of their deeds), then confidence could
be lost. As in Italy and other such places, where compliance rates on taxes
are very low.)

--Tim May

"The government announcement is disastrous," said Jim Bidzos,.."We warned IBM
that the National Security Agency would try to twist their technology."
[NYT, 1996-10-02]
We got computers, we're tapping phone lines, I know that that ain't allowed.
---------:---------:---------:---------:---------:---------:---------:----
Timothy C. May              | Crypto Anarchy: encryption, digital money,
tcmay@got.net  408-728-0152 | anonymous networks, digital pseudonyms, zero
W.A.S.T.E.: Corralitos, CA  | knowledge, reputations, information markets,
Higher Power: 2^1,257,787-1 | black markets, collapse of governments.
"National borders aren't even speed bumps on the information superhighway."

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