Unintended Consequences of tax policy

First Published: 2013-07-02

First published by Royal Fidelity, and posted here with the kind permission of the author.

’Curiouser and curiouser!’ Cried Alice (she was so much surprised, that for the moment she quite forgot how to speak good English).
–Alice in Wonderland

In his recent 2013-14 Budget Communication to the House of Assembly, the Prime Minister outlined a series of changes intended to address two main issues: increase revenue for Government and increase opportunities for Bahamian employment and growth. To emphasize his second point, the Prime Minister even mentioned the words “employment” or “job creation” a total of seven times in the first 11 paragraphs of his address.

While these are laudable objectives, the list of proposals to accomplish these goals can only be described as “curiouser and curiouser,” when you examine the real effect they are likely to have.

Many governments around the world have resorted to higher taxes and increased financial burdens on businesses as the cure-all for their fiscal ills. Problem is, higher taxes and increased financial burden on companies is likely to have exactly the opposite effect than what was intended. In the Bahamas, the dual proposals to dramatically increase business license fees and introduce VAT will likely choke off any prospect for growth and actually increase unemployment, entirely in conflict with the Prime Minister’s stated objectives.

You don’t need a PhD in Economics to come to this conclusion. All you need to understand is how a successful business operates. (“Successful” because non-successful businesses close!)

The Basics

Why do people open companies in the first place?

Typically, someone sees an opportunity to make money doing something they are skilled at doing. They take a risk, invest their hard-earned money in a business, and work diligently to make it successful. In turn, and quite rightly, they expect a return on their investment for themselves and shareholders.

Successful companies generate more revenue than they spend. They understand that in order to justify their investment of time and money, the latter must be smaller than the former. Much smaller. In fact, maintaining the appropriate balance between the two is the 24/7 preoccupation of nearly every successful business owner in the Bahamas and elsewhere, whether the business is a food store, mechanic shop, clothing shop, doctor’s office, plumber, bank, or restaurant.

When a government raises taxes — whether through the proposed introduction of VAT or the proposed significant increase in business license fees—they open a Pandora’s Box that cannot end well for either the business or the end consumer. Like the ripples that a pebble makes when dropped in a pond, the knock-on effect of such increases are felt across the country in innumerable ways.

Certain local business persons have already pointed out in the press the massive negative impact of the proposed increase in business license fees (one faces a $2 million increase in its annual tax bill; 60% of its projected net income), and hinted at the potential consequences.

The Big Squeeze

Faced with such an increase in license fees, businesses can choose to: 1) pass the increase onto consumers through higher prices; 2) absorb the increase as a cost of doing business; 3) reduce their expenses, or, most likely, 4) institute some combination of all three. However, each carries its own consequence.

If they raise prices, they lose sales because prices get too expensive. If they absorb the costs, they risk incurring a loss or reducing their profit to a level that does not justify their continued investment of time and money (ie-it’s just not worth the effort). If they reduce expenses, they typically lay off staff and cut down on purchases. This, in turn, results in fewer sales for the business, as well as fewer sales for the other businesses they would typically purchase from.

Consumers–who will be impacted by higher prices–also face some hard choices: 1) stop purchasing the higher-priced goods or services, or 2) find a cheaper way to get the same goods or services somewhere else. If they choose #1, they simply lower their standard of living and reduce their patronage of local businesses. Assuming that all local providers will raise prices in response to the increased/new taxes, then choosing #2 will logically lead consumers to shop outside the Bahamas for the same item. (Some persons, no doubt, will circumvent the costs completely by engaging in activity that falls outside of the law.)

If the good or service in question is essential—such as medical care, basic food, and basic housing—most consumers end up with no choice at all, but with even less in their pocket to spend on other items.

Cutting Business Expenses

In reality, when faced with proposed increases in taxes, businesses have only one real option: significantly reduce their expenses. Any idea what is typically the largest expense for any business?

You guessed it, employees.

Although unions might argue that laying off employees is somehow wrong or immoral, it’s a completely logical (and legal) course of action for a business to take in response to financial pressures placed upon it by a government. Most business owners try very hard not to lay off employees even in the face of such pressures. Many actively engage in charitable activities such as funding scholarships or participation in community organizations such as Rotary. Business owners in general are sympathetic to the realities of joblessness and no more wish to see it increase than they wish to close down their own business.

But ultimately, when it comes to survival and the justification for staying in business (ie-profit margin), companies often end up with few choices other than reducing staff costs.

Not the Whole Story

While raising business license fees and introducing VAT may help the Government increase revenue in the short term, the medium- to long-term effect will likely be exactly the opposite.

Not only will existing businesses freeze hiring and cut other expenses in the face of much higher costs, they will likely also lay off existing employees, further exacerbating the current unemployment problem. In addition, outside investors who may be considering setting up shop in the Bahamas are very likely to think twice now before committing capital to a business that can no longer produce adequate returns due to increased taxation. This both reduces growth and limits a potential source of new jobs.

As businesses contract, employment disappears, and new businesses decide to locate to more business-friendly jurisdictions (the Cayman Islands have begun actively promoting their Special Economic Zone, designed to attract international entrepreneurs) the Government could feasibly end up with a shrinking tax revenue base and increased unemployment. A vicious, downward spiral.

While an increase in tax revenues should be part of the solution, the current proposed increase in business license fees and introduction of VAT could be too much for both businesses and consumers to bear. Ultimately, and until the government is willing to confront the unacceptably high level of government expenditure as well as the inefficiency and astronomical costs of government corporations such as BEC – the real long-term reasons for the current debt problem in the Bahamas — we are all in for a “curiouser and curiouser” ride.

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