Why Taxes Matter:

You are analyzing a business opportunity that requires a $100,000 investment.

There is a 50% chance you will lose the investment, and there is a 50% chance you will double your investment. The potential return is :

-100,000 x 50% = -50,000
+200,000 x 50% = +100,000
The prorated risk return is $50,000 (the difference) or 50%.

Now let’s assume there is a tax on the gain of 20%

-100,000 x 50% = -50,000
+200,000 x 50% x 80% = +80,000
The prorated risk return is $30,000 (the difference) or 30%.

Now let’s assume some fool candidate wants to raise the taxes to 40%

-100,000 x 50% = -50,000
+200,000 x 50% x 60% = +60,000
The prorated risk return is $10,000 (the difference) or 10%.

Now you may think “Why should I risk $100,000 for a mere 10% when I can buy a secure bond, CD or even a mutual fund and get a similar return without the risk?”

The tax increase has just killed your incentive to invest. The additional tax on income has decreased the prorated risk profile, and reduced the rationality to take a risk. Job creation declines, tax revenues decline, unemployment increases.

This example is certainly overly simplified and there are lots of detailed differences between this and current reality; but it indicates how investors assess risk and how taxes affect the way they look at risk.

Bureaucrats believe they can fine tune the economy, and raise taxes without reducing the incentive to grow the economy. They are usually wrong for two important reasons:

The risk profile is constantly changing. Over seas opportunities, currency fluctuations, market booms and busts, interest rate changes, and industry dynamics constantly change the acceptable risk profiles. What was an acceptable risk profile last year may be totally unacceptable this year. No government policy or program is capable of understanding much less adjusting to such a change.

Secondly, risk profiles remain attached to human emotions. Terrorist attacks, stock market selloffs, and bank collapses strike fear into investors. A tax policy that may have had little impact on acceptable risk profiles for the last few years may suddenly have a severe adverse effect when the emotions of greed and fear are applied.

The recipe for growth remains:

Low taxes
Low regulation
Strong currency
Free trade

I believe Reagan said it best and true when he uttered,” You can not tax your way to prosperity.”

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