Thursday, June 16, 2011

Your Lemonade Stand & The Government

Hopefully Janie Johnson won’t be offended by me taking her lemonade stand example. This is a follow-up to yesterday’s post on corporate taxation inspired by a Twitter conversation. It offers a specific, simple, and yes, somewhat silly example of what I was discussing yesterday.

Here’s the scenario:

You create a lemonade stand business. You figure it will cost you $4 to get started, and another $1 to operate for a day, so you get the $5 in an interest free loan from Mom. You sell 12 glasses of lemonade at $1 each. Woohoo! Capitalism at its finest. You pay back the $5 to Mom, and your business is still left with $7. Since you worked so hard on the lemonade stand, you pay yourself a $2 salary.

Now your business has $5 left and you have dreams of expansion. You figure you can double your capacity for an additional $5 ($4 startup, $1 operating), and you still need $1 to operate your existing business.  That totals $6. That’s more than you have left, but you’re willing to take $1 of your salary and invest it into your business to get this expansion off the ground. So, you’re off and running.

Then Dad comes by. Dad mentions that he’s been protecting you and providing you with free housing, meals and healthcare. So, to fund his governing, he demands 25% of your profits. You hire your sister for $1 to handle the necessary paperwork and make sure that you’re in compliance with all of Dad’s regulations. You now have $4 left, and Dad gets $1 of that.

So, how much did the taxation cost your business? If you said $2 ($1 tax + $1 for your sister’s accounting), then you understand that the corporate income tax costs your business money. Congratulations. If you don’t understand that the corporate income tax costs your business money, then stop now. There’s no point in reading any further until you do.

Your business now has $3 of profit to reinvest in itself, but that’s not enough to cover the cost of expansion, and your dreams of growing your business are over, at least for now. So, this taxation has definitely hurt your business.

But Dad’s not done yet. He also takes 25% of you and your sister’s income for a total of $1.75.  This leaves you with $1.50, so even if you wanted to put your entire salary back into the business, you still don’t have enough to expand, and Mom has already said “no” to the idea of another loan. You’ll probably be able to afford to expand after tomorrow, but this corporate tax is definitely hurting your growth potential.

Now let’s look at a slightly different example. This time around, Mom doesn’t just give you an interest free loan. She invests in your business and wants a share of the profits. Also, every kid in the neighborhood has seen your success, and now there’s a lemonade stand in every driveway. You’re not going to be able to charge $1 per glass anymore.

So, here’s how your first day of business goes.

In order to deal with competition, you lower your prices, and you get a bigger pitcher. So, this time you sell 14 glasses of lemonade at $.50 each. You didn’t sell out because you spent so much time managing your business. There’s at least 4 glasses left over, but they’ll go bad by tomorrow, so you throw them out. Your business still made $7, which wouldn’t be so great if you had to give $5 back to Mom, but you don’t have to do that. You just have to pay her a dividend. You plan on a $2 dividend. But first, you pay yourself your $2 salary, and then there’s Dad with his hand out again. So, once again, you pay your sister $1, and pay your Dad $1 in taxes. Like last time, Dad takes an additional $.75 from you and your sister in personal income tax. Including your sister’s salary, your corporate taxes still cost your business $2.

Now, this time, rather than expanding your business, you just want to hire an additional employee. That will enable you to have more time to seek out new investors, figure out new ways to expand and increase profits, and possibly come up with new product lines like pink lemonade. You figure that a new employee will cost you $1. But if you pay Mom her $2 dividend, that only leaves you $1, which is what you need to cover the next day’s operating costs. So, either you’ll have to pay Mom a lower dividend, or you’ll have to cut back on your hiring plans. Note that either of these will negatively impact how much tax revenue Dad can collect.

We’ll say that you forgo the hiring of an additional employee and pay the $2 dividend to Mom. Dad gets $.50 of that, bringing his revenue up to $2.25. Yay, tax revenues are up! At the expense of crushing your business’s growth potential. Eventually, if you want to keep growing the business, you’re going to have to pay less in salaries or dividends.

Remember what I said were the three ways corporate taxes were passed on to others?

They pass the tax burden on to their customers in terms of higher prices, their employees in terms of lower wages and benefits, and their stockholders in terms of lower dividends.

Well, we’ve just seen two of them. Not hiring is the same thing as passing it on to employees. Your presumed new employee would have made $1. Since you won’t hire him, he’ll make $0. Or, to hire him, you’ll have to cut your own salary. Or Mom’s dividend.

Now, if you had raised your prices to $.75 a glass at the beginning, you’d have enough to pay your shareholder, Mom, her dividend, and hire a new employee. Assuming that your higher price didn’t cut into sales, that is. Probably an unrealistic assumption in this neighborhood, but we’ll go with it. And now you’ve done the third method of passing your tax burden on to others.

However, lemonade is used up pretty quickly. That’s the cornerstone of your business idea. You want to be able to sell new lemonade to your customers each and every day. The problems is that even if your higher prices don’t have an immediate impact, they definitely have a long term one. Your customers only have a certain amount of discretionary income available to pay for summer beverages. You’re going to make them run out of money sooner, and they will be forced to stop buying your product.

Since she’s an investor now, not just a banker, Mom might be willing to help you out more. Suppose she invests half her dividend, after taxes, back into the company. Now you’ll be able to hire that additional employee! Err...no. She only has $1.50 after taxes, so she only reinvests $.75. Unfortunately, that still isn’t enough for you to hire. This corporate tax thing is really screwing your business (bonus points if you noticed that a capital gains tax screwed your business too, but that’s beside the point right now).

Guess what? Dad has created some new financial regulations that might help you out! Rather than starting this lemonade stand business as a traditional corporation, you can form this thing called a scorp. Scorps allow you to avoid the corporate income tax. How? By passing it on to your shareholders. But wait, we already said that’s one of the ways corporate taxes are paid, so how does this change things? It doesn’t, all that much. And it doesn’t change the initial premise at all, which is that corporations don’t pay taxes. In fact, it reinforces it.

Using the previous example again, when Mom invested the $5 in your business, you sold her a 50% share of the company. You kept 50% for yourself, since the business idea was yours. You still sold 14 glasses of lemonade at $.50 each.

But, this time you had to pay your sister an additional $1 up front to file all the scorp paperwork. So, you need another $1 from Mom. Her investment is now up to $6. And you still had to pay your sister another $1 to handle the accounting showing that you stayed within scorp regulations and don’t owe any corporate income tax. You paid your own salary of $2. That leaves $4. You split the money with Mom, paying her $2, and bringing your total income to $4.

So, Dad gets $.50 from Mom for her $2 (yes, I know that it’s sometimes possible to offset capital gains with capital losses, but I’m trying to keep this simple), $.50 from your sister, and a whopping $1 from you for a total of $2. Your business has no capital, so you reinvest your $2, leaving you with $1. Mom only reinvests half of her post tax dividend, which is again $.75. You can finally afford to hire somebody, but at what cost? Well, it cost an additional $1 from Mom initially, and you only have $1 left of your $2 salary. Your sister is happy because she made an additional $.75 after taxes, but Mom is not. She invested an additional $1 and got nothing to show for it. You have less money in your pocket, too. This is hardly a win-win scenario. And it still cost your business $2 just to avoid paying anything in corporate taxes. In other words, the corporate taxes cost you $2, even though you didn’t pay any.

Now, what if there was no corporate tax? You sell your 14 glasses of lemonade for $.50. Mom gets her $2 dividend. You get your $2 salary. You get to keep your prices low enough to ensure a constant revenue stream. There’s $3 left over, so you pay yourself a $1 bonus for being such a good businessman, and you can still afford to hire someone.

And Dad? Dad gets $.75 from you and $.50 from Mom for a total of $1.25. Tax revenue is down initially, but starting tomorrow he’ll get an additional $.25 each day from your new employee. Your sister is mad because she didn’t get the $1 for accounting, but you hire her as your new employee. This is a good thing because she’s now part of production and sales, and not just overhead like she was before. Because of that, starting tomorrow, you’ll be able to sell all 18 glasses of your lemonade each day, bringing you an additional $2 in revenue, which you can use for dividends, higher salaries, or expansion. Dad will like the increased tax revenue from that.

And, since you have this extra employee, you have all this extra time and money to figure out how to make your business grow. You’ll soon be able to double capacity, hire another employee (fortunately, you have lots of siblings), perhaps even expand over to the next street. All these people you’re hiring have to pay personal income taxes, so pretty soon Dad’s not missing his corporate tax income at all (if he is, he can always raise the personal tax rate a bit to compensate, but since everyone’s making more money, that won’t hurt them nearly as badly). And GDP growth for your neighborhood is through the roof. Everybody wins.

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