Newton’s Third Law of Motion is simple and straightforward. For every action there is an equal and opposite reaction. Newton’s Third Law of Motion is as much a financial and economic term as it is for physics.
Incentives and restrictions placed upon people and businesses have the potential to both speed or impede demand for goods and services. Consider the Economic Recovery Tax Act passed in 1981. At that time the U.S. had a much greater marginal tax rate than it does today. As a result, any actions by the government that would provide protection from the high-marginal tax rates would be exceedingly sought after. Consider the following table showing the differences in the top income tax brackets contrasting 1981 with the current rates plus corresponding income hurdle levels.
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As you can imagine in 1981 there was a great incentive to avoid income taxes. Then along came the 1981 Economic Recovery Tax Act. In a simple deconstruction of the Act, it gave massive incentives to build new real estate improvements that could be depreciated at approximately twice the normal rate as previously seen. In essence, a person could own real estate that lost money, but due to the accelerated depreciation more than offset those losses by reducing the onerously-high marginal tax rates. In response, we saw record construction of new rental housing, offices retail and other properties. In 1981, for example, there were 425,682 multifamily residential permits issued in the U.S. By 1985 that had ramped up to an all-time record 761,200 units as the market was dramatically over-built. In comparison during the housing bubble, multifamily permits maxed out at 471,770 in 2005.
We had a professor of finance and real estate at Texas A&M that stated in 1985 that if we had provided the same stimulus to produce catsup as we had real estate, the world would have been six-feet deep in the red stuff. Newton was indeed correct. For every action there was a reaction. Tax savings trumped common sense.
How a government taxes different sources of incomes will alter how people spend and invest their money and capital.
Now examine which sources of income and spending that are more highly or less highly taxed in the U.S. compared to other developed countries and see how that impacts our spending and investment patterns. So how does the U.S. compare? The following table is from a study completed by the Tax Foundation of tax revenues across various member countries of the Organization of Economic Co-operation and Development (OECD).
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Since the U.S. tax rate on consumption is almost 50 percent less than the typical OECD country, there should be no surprise in that we are the among the largest consumer countries in the world of goods and services but have just 5 percent of the global population.
Consider also the comparative property tax revenue levels. While the U.S. collects $1 of every $9 of tax revenue from property taxes, the OCED collects just $1 of every $20 from property tax. This says there is a disincentive for homeownership in the U.S. It should come as no surprise that the U.S. just hit the lowest level of homeownership seen in the past 20 years. Just as Newton said, for every action there is an equal and opposite reaction.
The U.S., which relies heavily on income taxes today, is facing a headwind of declining income and wage levels. Is there any wonder as to why? There should not be.
Governments do require funding, but the elected leadership of the country needs to understand and appreciate the consequences of Newton’s Third Law of Motion.
Not all taxes are created equal. The implication and conclusions are that how a government collects their tax revenues will alter how individuals and businesses spend their money and allocate their scarce capital. We can only hope our elected officials in Washington, D.C. likewise have an understanding. Altering how we collect taxes will impact the economy.
To read the entire Tax Foundation report where a PDF can also be downloaded click http://taxfoundation.org/article/sources-government-revenue-across-oecd-2015?mc_cid=735c84a06d&mc_eid=c79ab314e3
Are any of you curious what was Newton’s First Law of Motion?
The First Law says that a an object will remain at rest or in motion in a straight line and will continue in the phase or trajectory unless compelled to change its course by an external action. I have always said that trends are easy to forecast, it’s the event that changes that trend that is difficult. Events are difficult to project.
Newton’s Second Law – let’s discuss that at a different date.
As for elected leadership of the country, there is probably a reason incomes are not going up, homeownership is heading down and construction as of this past month was off. Recall the country effectively increased the capital gains tax rate in 2013 by 57 percent. Who’s surprised at the lack of new construction? Not me.
Newton at heart was obviously an economist.
Ted