It’s about the margin

Even low tax rates can kill business and cause unemployment

By Geoffrey Lawrence
  • Thursday, December 30, 2010

"This tax isn't going to put anyone out of work!" lawmakers and pundits cried in 2009 as they debated whether to double the state's modified business tax. "It's only 1.17 percent!"

Yet, even "small" taxes impact business.

Sure, not all of the 24,790 individuals who are newly unemployed since the Nevada Legislature's 2009 tax hikes took effect can directly attribute their joblessness to the new levies. As global tourism demand has dwindled, so, too, have the revenues of Nevada's staple industries and those of the stores and services that cater to those industries' employees. This is a global recession rooted in systemic policy deficiencies.

But the state's 2009 tax hikes have done no favors for Nevada businesses or their employees.

Among the first lessons one encounters in a microeconomics classroom is that firms operate based on marginal — not absolute costs. More significantly, firms operate within the constraint of diminishing marginal returns for factor inputs versus consumers' diminishing marginal utility for the firm's product.

That is to say that every unit of a firm's product that has already been purchased by a consuming public satiates that public's demand for the product to the point where additional units are perceived to be of comparatively less value and, therefore, only capable of fetching a progressively lower price. At the same time, each new employee hired by a firm, for a variety of reasons, is likely to provide relatively less output per dollar of wages than the last employee.

Hence, there emerges, in every firm, an optimal production point where the amount of labor and capital employed maximizes profits and beyond which the firm begins to suffer financial losses. This is the scale of production at which the most efficient firms operate. Savvy entrepreneurs spend considerable effort conducting market research analyses to determine where this optimal production point lies and, by extension, how much labor and capital should be employed to realize this given scale of production.

Even small changes in this delicate financial balance can be enough to distort the marginal calculations. Payroll taxes such as the MBT (a tax assessed as a percentage of a firm's payroll) and the unemployment tax (which was just raised to 2 percent of payroll) as well as minimum-wage laws and health care mandates all artificially inflate labor costs and thus lower firms' profit margins. In many cases, this leads to dismissal of some marginal workers as firms are forced to bring their scale of production into accord with the new, politically manipulated cost structure.

An example: Acme Rockets, facing a completely free market, might determine that demand for its product is such that profits will be maximized by producing 600 rockets per year — the cost of producing a 601st rocket will begin to exceed the price at which it can be sold on the market. To do this, Acme must employ exactly 200 workers at the going market rate of $50,000 each for a total payroll of $10,000,000. However, when Acme is confronted with Nevada's MBT (1.17 percent) and unemployment tax (2 percent), it faces a new $317,000 liability to the state.

Thus, even in face of this relatively small change in cost structure, Acme's managers are forced to recalculate the marginal profitability of each employee. In order to maintain labor costs, Acme would have to lay off seven workers and cut back production slightly.

In this example, Acme is not forced to close its doors, but it is clear that Acme is forced to scale back production and lay off workers at the margin in response to even very small taxes.

Nevada lawmakers should heed this reality as they debate the impact of taxes in the future. While governments are obliged to levy taxes to finance their operations, it should be recognized that every tax destroys jobs and wealth. Therefore, to maximize community wealth and employment, taxation's burden should be kept to a minimum.

Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute. For more visit This article first appeared in the January 2011 edition of Nevada Business.

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