Samuel Cohn: Global Social Trends

In theory, high taxes are supposed to hurt small business. Presumably, small businesses operate on very thin margins.  Every single new expense, in theory, should increase the risk that a marginal business would fail and go under.

In theory, in poor nations, high taxes ought to lead to government corruption. Poor desperate owners, who have to do whatever it takes to keep their firm alive, might be better off bribing a tax collector rather than actually paying his or her taxes. The prospect of bribes ought to make big government pass lots of taxes and create lots of regulations so that the enforcers can collect a lot of bribes by businesses seeking to avoid enforcement. This kind of venal predatory policy is called rent-seeking by economists. It is a real issue in the most corrupt countries of the world.

At one time, I genuinely believed that high taxes crushed small business and by doing so set back the cause of economic development. I generated my great master plan. I was going to go to a high tax country. I was going to study an industry where all the firms are marginal and small. I would do rigorous statistical analyses and show the job-destroying nature of high taxes.

I had a great opportunity because Brazil at one time actually published data on the amount of taxes collected by each firm. Yes, it was self reportage; they asked owners to report how much in taxes they had paid. Yes, everyone lies to the government. Yes, everyone says they have paid more taxes than they really had. But there is no reason for people in one part of the country to lie more than another. I figured that I could compare the number of barber/beautician jobs in high tax states and low tax states, figuring the people in high tax states would probably be likely to say they paid more. I expected the states with high taxes would have fewer barber/beautician than states with low taxes, because naturally, high taxes kill jobs, right?

I did all the methodologically correct things. I statistically controlled for other factors that could increase employment levels. To make sure that I was not getting some crazy artifact of the hairdressing business, I ran parallel tests on hotels and on restaurants. I looked at multiple years to make sure that the results were robust. And just to make sure my statistics were right, I went and interviewed barbers and beauticians live and in the flesh, asking them the conditions that accounted for their success and the success or failures of other barber/beauticians in their area.

The news was not good. The equations showed taxes having no effect on the number of barber/beautician jobs in the state. It is not that the equations were badly behaved. All of the other reasonable variables such as income and urbanization did what they were supposed to do. Another factor that was supposed to matter – high rents – did what it was supposed to do too. High rents killed barber/beautician jobs because they could not find commercial space.

Other industries showed the same issue. Taxes had no effect on hotel jobs or on restaurant jobs.

The barbers and beauticians themselves confirmed that the equations were right. None of them reported tax problems. None of them thought the taxes they had to pay were a big deal. All of them argued that other things were more important to determining success as a barber and beautician. The most common factor they mentioned was skill. Brazilians take their appearances very seriously. This is particularly the case for Brazilian women. Brazilian women are fashion conscious, make-up conscious and routinely undergo plastic surgery to maintain their good looks. A Brazilian beautician who cannot make her customer look spectacular will not last in the business very long.

I confirmed the barbers’ story about the irrelevance of taxes by looking at the actual expenses of barber/beauty shops. The same source that reported tax payments also reported raw material purchases, rent payments and labor costs. Tax payments represents just slightly over 1% of total receipts. It was a far smaller component of total costs than were raw materials and rent. Tax payments being 1% of total receipts is likely to be an over-estimate. The respondents were talking to government census takers – so they had every incentive to show they were law abiding business people who regularly paid all their taxes. So their estimates of tax payments are probably high. They had no incentive to exaggerate their payments for raw materials or rent.

So if tax payments are no big deal in a high tax state, among the smallest and most vulnerable of small businesses – how important are taxes as a factor in determining the survival of businesses in countries with lower tax bills or for larger businesses that have greater financial cushions.

I think taxes are probably not much of a factor at all.

As the barbers themselves told me many times, business success is based on your skill and competence in actually running your business.

I picked a country where taxes were generally high – Brazil.

I picked an industry were firms are very small and operate on the thinnest of profit margins –  barber and beauty shops.

I did the statistical analyses.

The findings blew up in my face.

Brazil is an absolutely high tax setting. Brazil is known for a particularly expensive form of taxation known as the cascada or “waterfall”. Most nations (not the United States) have a value added tax in which companies pay tax on the net value added by their vendor. So if a manufacturing company buys steel and makes auto parts, they have to charge their customers the difference between the price of the steel and the price of the auto parts. In the Brazilian system, you don’t get to discount the price of the steel. If steel goes into auto parts you get taxes on the full price of the auto parts, steel and all. So the Brazilian government gets to collect tax on the raw materials at every stage of the production process. Service firms, like barber shops, also have to pay a tax on service receipts. They pay property taxes. They pay payroll taxes which include social security, paid vacations, holiday bonuses, medical insurance, unemployment insurance, and worker’s compensation. They have to contribute to government vocational training funds and they also have to contribute to the federal small business administration. Other countries have such taxes too. But the level of taxation in Brazil is high, particularly by Latin American standards.  José Pastore, a Brazilian anti-tax activist has done the calculations of how much tax a small business would have to pay in Brazil if they followed the tax code to the letter. The percentage of receipts that would in principle go to the government is staggering.