Marcie is ready to launch her new business.  The business plan has been polished and re-polished many times.  Like most small business owners, she plans to finance growth with reinvested after-tax earnings and bank financing.  Her projections assume a gross margin of 50 percent, variable expenses of 29 percent, and the ability to borrow two dollars for each dollar of reinvested capital.  They also assume that the business will be subject to an income tax rate of 34 percent, the rate applicable to most profitable corporations with a taxable income of less than $10 million.

Marcie’s projections show that, by the end of year 10, she will have reinvested sufficient after-tax earnings to grow her sales to $3.3 million and to add 12 employees to the company’s payroll at an average annual salary of $60,000. Her net income before taxes in year 10 will be $607,000, and, at a 34 percent tax rate, the business will pay slightly more than $200,000 in income taxes in year 10.  The aggregate federal income taxes paid during the business’ first ten years of operation will total just over $479,000.

Marcie has heard rumblings of a potential reduction in corporate tax rates to 25 percent.  So, just for kicks, she changed the assumed tax rate in her projections from 34 percent to 25 percent.  All other factors and variables remained exactly the same.  She was shocked by the results.

This single change in the tax rate assumption would provide her sufficient capital to grow her business to $5.4 million by the end of year ten – a $2.1 million increase over the prior scenario.  As she carefully reviewed the numbers, she discovered that the additional amount reinvested each year as a result of the lower tax rate would have a compounding effect in each subsequent year and facilitate higher bank leverage.  The faster growth would result in the business employing 20 people by the end of year 10, eight more than under the prior scenario.

How much would such a rate reduction cost the government in lost tax revenues?  Zippo.  In fact, Marcie was surprised to discover that she would end up paying more federal income taxes under the rate reduction scenario over the next ten years.  The aggregate taxes paid by her business during its first 10 years would total $549,000, roughly 15 more than the prior scenario.  Her tax bill in year 10 alone would be nearly 23 percent higher with the lower tax rate structure.

How is this possible?  As Marcie studied the numbers, it was obvious that the increased income taxes resulting from the faster growth of her business would more than offset the tax effects of lowering the rate.  It confirmed to her that less really can be more when it comes to business tax rates.

But the revenue benefits to the government would go far beyond Marcie’s higher tax bills.  Marcie’s business would employ eight more people under the lower rate/faster growth scenario.  These eight people would stop collecting unemployment benefits and start paying income taxes.  More importantly, 15.3 percent of every dollar paid to these additional eight employees would go straight to the federal government in the form of regressive payroll taxes.  Plus, eight more people would have incomes that could be spent to strengthen other businesses.  Business growth fuels additional growth, and all growth feeds government coffers.

So who losses with a smart reduction in business tax rates?  Marie would have additional capital to grow her business faster.   For more people (66 percent more), the joys of productivity would replace the despair of unemployment.  And government revenues would escalate on all fronts.  There is no loser.

But Marcie’s numbers do confirm one other consequence of a lower rate structure.  Marcie would become a rich woman much faster.  And that simple reality of lower business tax rates drives some people absolutely crazy.

May 16, 2012