The "wealthiest" tax rates matter to everyone

The debate over extending the current tax rates is raging, and we believe that the most important economic consideration is being left out of the argument by both sides in this debate.

Currently, the argument is being framed something like this: one side proposes the extension of the current lower rates for "the middle class," but letting the lower rates expire "for the wealthiest Americans" (this group considers those earning over $250,000 in income per year wealthy), while the other side is arguing that the lower rates should be extended for everyone.

Those who believe lower rates should be extended for everyone generally put forward the argument that many small businesses could see their taxes raised, and that "we can't raise taxes on small business in a fragile economy". This simply ignores the fact that while the economy is not growing as fast as one would hope, the economy is expanding and has been since roughly June 2009.

There are several problems with this argument. First, it assumes that raising tax rates is fine, as long as we are not in a fragile economy or a downturn! We would argue that low tax rates are critical for growth and innovation at all times (see here and here for previous posts on that subject).

The bigger problem is the inability to explain why raising marginal tax rates on the highest income levels hurts everyone. Even if small businesses were somehow excluded from the increase in rates for those earning more than $250,000 per year, the impact of the tax hike on upper income brackets would be crippling to growth and innovation. This is true because, as Art Laffer points out in an article we've linked to previously, "one should expect a greater supply-side response with a change in the highest tax rate than with any other rate."

In other words, if the rates were raised for all dollars earned above $250,000 and someone earned $250,001 in a particular year, the higher rates would only be applied to that extra one dollar (the lower rates would be applied on all the dollars earned up to $250,000). On the face of it, this fact makes it seem like an increase in the rate charged on that final one dollar is not such a big deal -- but on the contrary, it proves the point Art Laffer is making above. If the government is going to take a bigger percentage of that final one dollar, but not as large a percentage of the previous two hundred fifty thousand dollars, then people are less likely to work harder for that last dollar.

The choice to try to make more or not is intensified at the highest bracket. When the marginal tax rate on the highest bracket goes up, people who are in the position of making that one extra dollar dramatically scale back their decisions to do so -- it is perfectly logical cause-and-effect.

While this might not seem like such a big deal when those people are described as "millionaires and billionaires" popping thousand-dollar bottles of champagne every night with their dinner, it is a fact that innovative businesses that create new jobs are overwhelmingly financed by those who are making this very decision on whether to pursue those marginal extra dollars or not.

As we wrote in this post almost three years ago:

"If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

"Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy."

If those who finance innovative businesses decide not to pursue that "extra dollar" (or extra few million dollars), then new drugs and cures will not be funded (take a look at the recent movie Extraordinary Measures for insights into how new medical advances are financed), advances in consumer technology will not be what they could have been, and in general the economy and quality of people's lives will be retarded.

This is the argument that is being overlooked by both sides. One side is saying that "millionaires and billionaires" don't need a tax rate cut at all, while the other side is arguing that the rate cuts should be extended to everyone, because of small business or the fragility of the economy. While small business is important, it is not the main reason that marginal rates in the highest bracket are critical to everyone.

Sadly, very few people in the US understand this argument, as evidenced by this recent Gallup poll, which shows that, while 40% want the tax rate cuts extended to all, the percentage zooms to 83% when the tax rate hikes are withheld from "the wealthiest Americans," with some of the additional 43% setting that "wealthy" limit at $250,000 and some setting the bar higher, such as for those earning over a million dollars.

It's not really their fault -- nobody on either side ever cares to explain this to the American people. Nobody ever takes the time to explain how critical financing is to things that make a real difference in people's lives, and how critical the highest marginal tax rate is to those big-dollar financing decisions. Please pass this post on to your friends and family as a way to shed some light on this critical subject.

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