Normally in business you want to know “the how” to do things better. But sometime it is good to know “the why” things are the way they are as well. Take taxes. Of course, we all want to change them, but it is also good to know some of the “why” behind them. 

My colleague, a UAF accounting professor, often asks his students, “If you don’t have taxes, then how would you pay for government services?” One answer is pretty apparent to anyone who has studied colonial history: inflation could make a pair of shoes cost a thousand Continentals (the colonial era currency). That is, the government prints money to pay for its services and this creates inflation. But another alternative is for the government to simply confiscate land or other assets and sell them off.

The U.S. did that for example in the late 1800s by acquiring 20 miles of land on both sides of the Trans-Continental railroad to pay for the railroad and U.S. government services. That payoff lasted until 1913 when the 16th Amendment to the Constitution allowed the government to impose an income tax. As Benjamin Franklin said, “Nothing is surer than death and taxes.” 

Still, businesses have to contend with planning for the future when there are tax changes,such as the 2017 Tax Cuts and Jobs Act (TCJA) which took effect in tax year 2018. And businesses want to understand why there can be such complex calculations when a tax is levied. A flat percentage of profits tax is the simplest tax, but there are also sales, income, progressive, regressive, head and a myriad of other taxes. 

Still, if you have a profits tax, how do you even define profits? In capital gains, where you buy low and sell high, a high capital gains tax often reduces the number of trade transactions that take place and the government actually receives less revenue than with a low capital gains tax. In that case, then, the question is not what is the simplest tax, but what tax gains the most revenue. Other questions are: what tax is fair? or what tax is conducive to economic growth? 

In measuring profits, one of the most common occurrences is when an early high cost investment is followed by a later high revenue gain. When that happens, the term profit has little meaning because a profit is simply revenue minus costs, but the costs happen in an early year, and the revenues happen in later years. Therefore, the early costs have to be matched to the later revenues. And the way to do that is by using what is called depreciation. Now, the usual idea of depreciation is simply where your asset declines in value, like how your dilapidated 1991 “Big Doolie” pickup truck requires you to pay someone to cart it away. 

But for tax purposes, the term depreciation is where early costs are matched to later revenues in order to calculate a true profit. If you build a hotel, even if eventually the hotel will be resold for close to the same amount you paid to build it, there was still all that early cost that later revenues had to cover. So the tax authority has to come up with one or another rate of depreciation to match the early costs with the later revenues so that you don’t just tax revenues without reducing them by the costs of building the hotel.

As an alternative example, the depreciation of computer games may need to happen within five months, after which the game becomes “so five minutes ago,” and is no longer popular. So there is no one depreciation rate that works for all contingencies, which then causes complex tax systems to be developed. 

So, taxes tend to be complicated due to business being complicated and therefore you often need a tax professional to figure them out. Of course, when Adam Smith first wrote The Wealth of Nations, the East India Company basically had a monopoly over tea, spices and manufacturing and the British Monarchy extracted a simple royal licensing fee, a de-facto tax, from the company. Nevertheless, Smith reacted to that royal monopoly by suggesting that by having a profits tax rather than a fee and in addition having more competition, Britain would have lower cost tea, spices and manufacturing and higher tax revenues and indeed have more income and jobs, i.e. a greater wealth for the nation. That darn Adam Smith, always ruining things for monopolies.  

Dr. Douglas B. Reynolds is a professor of Economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at DBReynolds@Alaska.Edu. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.