You often here things like, “It costs so much to live in the city,” or “Things always cost more in the city.” Do you ever wonder why? It’s the taxes. Today we’ll look at the effect of taxes on the price of things you buy, which causes prices in high-tax areas to be way higher than prices in low-tax areas. Ironically, higher taxes does not necessarily mean governments bring in more money per capita, as described in a theory called the “Laffer Curve.” We’ll discuss why.
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How goods are priced
To understand why taxes cause prices to be high, you first need to understand how things are priced. If it is a free-enterprise society where business owners are free to price things as they see fit, the most critical aspect will be the cost of the item. When pricing an item, the owner first calculates his costs to make (or acquire) the item, market it, and sell it since he needs to charge more than that to make a profit. He then surveys the market and determines the cost the most customers would pay for the item. In doing this he looks at who else are selling similar items and for what they are selling. As long as there are enough businesses selling an item, at least one of them will try selling at a lower price than the others to gain market share, which will cause the others to lower their prices. This will continue until the item reaches the minimum point at which it is still worth selling.
This means that basically, as long as there is enough competition and there isn’t collusion to fix prices, all items in the marketplace are priced about as low as they can be, taking cost of making and selling the items into account. Once this happens, everyone will sell like items for about the same price since they’ll sell fewer and make a lower profit if they try to sell for more. If businesses try to sell for less than this price, they’ll find they’re selling items but not making enough in profits to be worth their time.
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This is the beauty of a free-enterprise marketplace: the customers get the lowest possible price because businesses are always looking for ways to lower prices by cutting their costs. There are a few items where this doesn’t occur because the customer associates a high price with quality, desirability, and exclusivity (like exotic sports cars) and the sellers do better by charging more. People buy Rolls Royces because they are expensive and not many people can have them. But in general it is true that prices are driven down to their minimum point.
Free enterprise works in big cities too
Now, you may think that businesses can just charge more because they are in a big city and there is a lot of competition for goods. It is true that if you have enough people as possible customers, you can probably charge a higher price for things and find enough people to buy the goods at that price, but this does not explain the price differences. If businesses are all selling hats for $20 each and someone comes in and starts selling them for $10 each, they will take business away from the other shops because most people aren’t going to pay $20 for something that they can get for $10. As long as you have enough businesses, someone will eventually lower their prices to gain market share, so prices will reach the minimum point.
It also isn’t that there are a limited number of shops. There are a lot more shops per square mile in places like NYC than in places like Fargo because there are a lot more shoppers on foot. It is true that land is limited, but because cities build upwards, there is effectively limitless space. If there weren’t enough room for enough shops on the ground floor in a big city, people would start businesses on the second story. Those on the ground floor would have an advantage because it would be easier for shoppers to visit them, but those on the second floor could take away that advantage by charging lower prices.
Prices in big cities are based on their costs just as they are everywhere else. And it isn’t like it is the cost of getting goods to big cities that leads to the high prices because it is far easier to get goods to Los Angeles than it is to get them to Lincoln, Nebraska. Things cost more in remote small towns because of shipping costs, but not in big cities where all sorts of trains, trucks, planes, ships, and river barges stop. So, why would things cost so much more in big cities?
Taxes are a cost
One of the costs that go into the price of goods is taxes. Business taxes, income taxes, real estate taxes, payroll taxes, high minimum wages (which are like a tax in that they add to sales cost and imposed by a government entity), fuel taxes, energy taxes, etc… all add to the cost of a good or service, so they add to the price. This means that stores in high-tax area will need to charge more than those in low-tax areas. Sales taxes are added after the sale, so they are less of a factor (but they do add to the cost of goods if they are added to transportation costs, services, packaging, etc… that the business needs to pay) but they may also lead to businesses moving to another area if sales taxes are less since that’s where the customers will go, especially for high-cost items.
Note that this has a cumulative effect. Businesses need to pay for things too, so if the price of a delivery service includes taxes for the service of fuel, it adds to the business’ costs. Taxes on real estate increase the rent that the business pays, so they charge more. Employees need to pay more for things because of all of the taxes, so they require higher wages before they will work, which increases the cost of things. Before you know it, a pretzel costs $5 in NYC where it costs $2 in Birmingham.
And realize that it is the customer who pays all of the tax. Politicians want to make it sound like they are going to get businesses to pay higher taxes when they propose them, but businesses do not pay taxes. It is the customers who pay. If every business needs to raise prices because taxes go up, it means there is no reason for a business owner to pay for any of the tax. The customers will pay because they have no choice but to pay it. This would not be the case if a business could somehow avoid paying the tax since then they would charge less to take market share. In that case, a business couldn’t pass on the cost of the tax.
Want lower priced items? Demand lower taxes.
So, if you want to pay less, demand lower taxes. Places like NYC and Chicago have elected politicians that raise taxes for decades. This has resulted in radically higher prices for things. Wages are numerically higher, too, but since everything costs more, employees don’t really get ahead. Because they’re making higher wages, they also end up paying more in federal income taxes and lose tax breaks that those in lower-tax areas get because of their lower incomes. The only time that those in high-tax areas actually get an advantage is when they move to a low-tax, low-cost area and are able to buy a house for far less. They normally drive up the prices for houses in that area then, however, and also start to insist on some of the amenities they had in the places where they left, driving up tax rates and creating the same sort of high-cost environment that they left.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.