How to Solve the Fixed-Costs Crisis

The Atlantic

Congress is working to craft an economic response to COVID-19 with admirable speed, open-mindedness, and focus on the specific goal of alleviating economic hardship. As the idea of sending immediate cash payments to households appears to be generating broad-based consensus, congressional attention is turning to the question of how best to assist businesses paralyzed for the sake of public health. The simplest and most effective solution to this problem is the creation of a Public-Health Takings Fund, to compensate businesses for the fixed costs they will incur while closed in the public interest.

Helping the hardest-hit businesses is difficult. On the one hand, we cannot send everyone the total revenue they might otherwise have earned during this period—it would be impossible to calculate, prohibitively expensive, and the end result would be a massive windfall for owners who get to cash checks without incurring the expenses of day-to-day operations. On the other hand, otherwise healthy businesses will go bankrupt in the face of long stretches with no revenue, even if they don’t have to pay their day-to-day expenses.

The key here is to recognize that businesses have two kinds of expenses: fixed and variable. Think about your local coffee shop. It has some fixed costs that it must pay regardless of whether anyone comes in, such as rent or a mortgage, and interest on the loan for that fancy espresso machine. Then it has variable costs that it pays based on customer demand, such as wages and the cost of ingredients. Each time you buy a cup of coffee, some of the price covers the variable costs of making that cup. What’s left over is called the “gross margin.” The coffee shop counts on generating enough gross margin from enough cups sold to cover those fixed costs.

Recommended Reading

When we tell the shop to close down for a month, it can cut its variable costs (including, unfortunately, through layoffs), but not its fixed costs. When the shop isn’t earning that gross margin on each cup, its fixed costs keep accumulating and can quickly overwhelm any reserves it may have saved. Support that covers all the lost revenue would be excessive; what is needed is support in proportion to fixed costs.

Note, also, how this challenge differs from that of a typical debt crisis. Interest payments on debt are one form of fixed cost, and a firm that takes on too much debt can find that even a small downturn in sales—or even no downturn at all—leaves it without enough gross margin to cover the interest owed. But here, with revenue collapsing to zero, through no fault of the business owner, the crisis has nothing to do with excessive leverage. Even if the coffee shop borrowed responsibly, or didn’t borrow at all, other fixed costs could still become crushing.

How to help businesses facing a total revenue collapse cover their fixed costs? A good place to start would be in the Anglo-American tradition of compensation for a government taking, best known in the United States from its appearance in our Constitution’s Fifth Amendment: “Nor shall private property be taken for public use, without just compensation.” We recognize that government must sometimes take private property, as when it uses eminent domain for the construction of a road or pipeline. But we also recognize that when it does, it must pay.

The shutdown of commercial establishments necessitated by our public-health crisis is, in a sense, such a taking. Not necessarily in the constitutional sense—a complex jurisprudence has evolved on the question of when government regulation of a property’s use might rise to the level of “taking,” and my suggestion here is not that current conditions necessarily qualify or that our government is therefore compelled to provide compensation. Rather, in common sense: The coffee shop owner would like to operate his business and we, the public, need him not to. He has not failed in business; to the contrary he has succeeded and, but for public need, his shop would have customers. He is paying for property, the economic use of which we have entirely deprived him. Shouldn’t he be compensated?

A Public-Health Takings Fund could, and should, reimburse business owners deprived of the profitable use of their real property by public-health imperative. Thanks to the widespread existence of well-documented mortgages and leases on which businesses have made regular payments, determining the amount of compensation will in most cases be straightforward. Compensation should be available to businesses closed by local, state, or federal regulation, for the duration such rules remain in effect. It should require continued maintenance and upkeep of the property. Importantly, it should be a grant, not a loan—it is not a new resource, but rather compensation for a cost incurred. If businesses are saddled with additional loans that they cannot use for forward-looking investment, they will face higher fixed costs with nothing to show for it long after the present crisis ends, leaving them more fragile and with worse prospects.

The fund would come nowhere near covering all fixed costs or all businesses, but it would allow many of the most vulnerable to remain afloat through the crisis, without any undeserved windfall to recipients. It would ensure that landlords and banks continue to receive their payments, preventing at least this facet of the crisis from cascading into the financial system. And it would represent an acknowledgment that we as a society are asking these businesses to close and we should help bear the cost; not through a bailout, but rather a sharing of this unfortunate burden.

For individuals, while widespread cash payments appear increasingly likely, an important debate remains about whether and how to means-test them, so that only households below some income threshold receive support. On the surface, means-testing seems entirely reasonable—Jeff Bezos doesn’t need a $1,000 check! But it would create two problems. First, means-testing is complex and doing it well slows the process of passing and implementing legislation. Second, means-testing is inevitably backward-looking, which ensures that it misallocates support in a time of crisis. The people in greatest need are not just those who had low incomes last year, they are also those experiencing sharp drops in income now.

A better approach than means-testing is to claw back payments to high-income households through the tax code. If we designate these crisis payments as a separate category of income to be reported on your year-end tax return, we can assign a tax rate to that category based on your regular income during this year. The formula could be as simple as doubling or tripling the marginal tax rate on the filer’s ordinary income. So if your income for this year puts you in the 35 percent tax bracket (roughly $200,000 to $500,000 of earnings), then you will have to give back 70 percent or 100 percent of your crisis payments. For low-to-middle-income households in the lowest tax brackets, the rate on crisis payments can be set to zero. The result would be cash to everyone right away, which ultimately functions as a grant to those in need and a loan to those most able to pay it back. This would make distribution much easier, and the eventual adjustments and calculations more straightforward.

Both a takings fund and a tax claw-back would require much further elaboration, but policies along these lines could help to quickly address some of this crisis’s most pressing challenges.