The negotiations over the fiscal cliff are constantly going back and forth, and one of the thorny issues, as usual, is taxes. President Obama wants to raise rates and the GOP wants to cut loopholes and reduce deductions to raise revenue.

I'm not here to debate the merits of either plan from a political standpoint, as The Motley Fool isn't the forum for that kind of political debate. What does matter is how tax rates impact businesses and by extension our investment profits. Warren Buffett has famously said that he doesn't know a single business owner who has made an investment decision based on tax rates, something that some have refuted, but since he is Warren Buffett, his words have weight in the debate.

So do tax rates matter? And if so, to whom?

I'll try to break it down from a mathematical standpoint and point out the rates that matter to businesses and investors and how it will affect the market going forward.

The theory behind the madness
When a company is considering an investment like a piece of equipment or an R&D project, its financial analysts create a model to weigh the outcomes. These models include outflows of cash to make the investment and inflows of cash that are the return on that investment. Whenever there's an inflow of cash, taxes matter, which is why rates matter to this analysis. 

The rate that companies pay or use in models may change based on location, business type, or any number of factors. But the basic premise is the same: Taxes are part of the equation.

So, let's do a very simplified financial analysis of a hypothetical project and see what taxes do to its return. I've laid out the assumptions below, including 0% inflation and 0% growth initially. We'll assume that there's a one-time cash outflow of $100,000 today (for example, to buy equipment) and that the investment will create cash flows for 10 years in equal amounts starting one year from today before becoming obsolete. 

Capital outlay today

$100,000

Required return on capital / discount rate

10%

Years the project will produce revenue

10

Earnings before taxes and depreciation expected per year

$19,653

Tax rate

35%

Net income per year

$16,275

Rate of return

10%

Source: Author's calculations. Assumes straight-line depreciation allowance for tax purposes.

If we calculate a rate of return, or IRR, for this project, we find that the return is exactly 10%. Based on the cost of capital of 10% in this company, it would be wise to pursue this project because the return on investment is exactly the cost of capital. Notice that I have not included revenue, margins, or other items; these don't matter to the investment thesis as long as we know pre-tax profit and include any other investments in our initial capital outlay number.

Now if we do the exact same project and only change the tax rate, the dynamic changes.

 

30% Tax Rate

35% Tax Rate

40% Tax Rate

Pre-tax profit/yr

$19,653

$19,653

$19,653

Taxes

$2,896

$3,378

$3,861

Net income/yr

$16,751

$16,275

$15.792

Return on investment

10.7%

10%

9.3%

Source: Author's calculations.

Based on this table, tax rates make all the difference in the world when deciding if this project is worthwhile. If rates are 35% or below, we would go forward; if they are higher, we wouldn't.

Other important factors
So, if tax rates are so important to businesses and investors, why has fellow Fool Morgan Housel concluded that tax rates have little correlation to GDP growth? Logic should tell us that lower tax rates will always lead to higher return for investors/businesses and therefore more investments by investors/businesses.

The easy answer is that growth often has the largest effect on most financial models. A 2% change in the growth rate has an even greater effect than a 5% change in the tax rate. Here is the same ROI calculation just like I did above except I've modeled three different growth rates (still 0% inflation).

 

30% Tax Rate

35% Tax Rate

40% Tax Rate

0% growth

10.7%

10%

9.3%

2% growth

12.1%

11.4%

10.6%

4% growth

13.6%

12.8%

11.9%

Source: Author's calculations.

As you can see, growth rates have a big impact on returns as well.

The big lesson here is that a multitude of factors matter when businesses make investment decisions. Taxes matter, growth matters, costs matter, and so do a lot of other factors.

The investment equation
I haven't touched on capital gains yet, and there's a good reason for that. Capital gains rates don't have anything to do with a business's day-to-day decisions because businesses don't pay capital gains on typical business investments -- owners do. So what changes for an owner?

An owner provides one of the key inputs for the cost of capital that I discussed above. They'll decide how much return they need from an investment, and on the stock market they'll adjust the price of the stock accordingly.

So, if an investor requires an 8% return on investment and capital gains taxes are 20%, the company's cost of capital is 10%. In theory, this means that higher capital gains rates should mean lower stock prices and vice versa.

A never-ending debate
Taxes are a complicated and confusing debate for governments, businesses, and investors. It's a balancing act and there are no hard and fast rules with tax rates. Lowering taxes doesn't always lead to more business investment (see the 2000s) and higher taxes also don't mean slow growth (see the 1990s).

What we do know is that taxes are a contributing factor when businesses and investors make decisions. On a purely theoretical basis, lower taxes will make more projects financially viable and businesses will choose to invest more. If only reality were as simple as theory. 

link

Fool contributor Travis Hoium has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.