Keith Hennessey says

A tax increase enacted into law now, to take effect in 2013, is only slightly less discouraging to economic growth than a tax increase that takes effect immediately.  A CEO who knows her firm’s taxes will increase in 2013 will be discouraged from hiring, investing, and building now.

The immediate question is why would taxes discourage a CEO from hiring workers or buying new equipment. I used to think that people were assuming fairly sophisticated models from which you can derive this thinking, but the more I have been on the blogosphere I think they are simply using the rule of thumb that when you tax something you get less of it.

Well, maybe.

Here is the problem with applying that logic to a business. In theory a business exists to maximize profits. And, taxes are charged on profits.

However: whatever maximizes profits also maximizes profits divided by two.

Suppose that you figure out the number of workers to hire and equipment to buy and it maximizes profits to hire 50 workers and buy 15 trucks.

Now the government comes along and says its going to take half of all of your profits.

What should you do?

You should hire 50 workers and buy 15 trucks.


Because, doing so gave you more profit than all your other options. If after-tax profits are 50% of before tax profits then that same plan will still give you more profit than all your other options.

The perhaps bigger rule of thumb is that economics rents and taxes always accrue to the factors of production. Another way of saying this that might make more sense to my conservative readers is that you can’t tax a business you can only tax people.

The flip side of that, is that taxes that do not discriminate between businesses do not change optimal business decisions. What they do, do is lower the return to capital. That in turn could lower the amount that people invest. That in turn could lower the capital stock.

However, you wouldn’t expect – at least in this simple model – for taxes on businesses to have any immediate incentive effect on business decisions. We can introduce things like cash-flow constraints and the breakdown of Modigliani-Miller, but these are actually Keynesian effects, not incentive effects.