The debates in the class war classifies wealth in the extremes.  We hear about Wall Street billionaires and the unemployed but we miss the vast majority in the middle.

We sometimes refer to them as the working wealthy.  Most small business owners are in more common businesses such as service providers, welding shops, dry cleaners, small restaurants, auto repair shops, and retail stores.  This is a far distance from great innovators such as Apple and Facebook.

Most small businesses compete in a game of inches.  They compete with many similar businesses and face many uncertainties.  When extending credit we note how many potential customers are a single truck wreck or a divorce away from bankruptcy.

In a game of inches you get little credit for doing things right but you face stiff penalties for doing anything wrong.  A single workmen’s comp case, an EPA law suit, a sudden rise in health insurance cost or property and casualty insurance, a jump in fuel prices, a change in the bank’s credit policy, a single customer’s default, or any number of unexpected and unplanned events can mean the difference between profit and loss, survival and bankruptcy.

These friction costs are well known to business owners.  The government is often the biggest source of these friction costs.  Not only does the prospect of higher taxes threaten a small businesses future, but increased regulation can have just as big an impact.  Even worse is the fact that the laws and regulations you must abide by change so much that you can never measure the impact or benefit because so few have any confidence that the rules in place will remain in place.  Tax cuts are passed with expiration dates, reducing any long term impact, but onerous regulations remain forever and just grow in number and complexity.

We are seeing doctors leave private practice to become hospital employees as the friction costs drive them from their businesses.  The burdens of business ownership keep people from going out on their own and cause an increasing number to close. Most of these will never reopen.

A business owner with a Subchapter–S organization (a common structure) may make a taxable income of $250,000, making him wealthy in the arbitrary eyes of the  president, but that does not mean he received $250,000 in cash compensation.  He may have drawn a salary of $100,000 and the other $150,000 which is reported as TAXABLE profit was reinvested in accounts receivable, inventory or capital equipment. A 30% tax on $250,000 is 75% of the actual cash he draws as salary in this example.  The means that growth either requires extraordinary profits that few have, increasing debt, or paltry cash returns for many businesses.

Job growth is weak because friction costs are high.  It is really that simple.

Supply side economics remains controversial and poorly understood both by its critics who think it is just  ‘trickle down’ economics: a thinly veiled rationalization to improve the lives of the wealthy at the expense of the poor, and by many of its proponents who think that cuts in tax rates will always increase tax revenues.

Both are wrong.  I wrote Understanding Supply Side Economics for American Thinker (6/24/11), to address those who cannot look beyond the ‘trickle down’ description.

An excerpt:

Secondly it shows that there are usually two different rates that will generate the same revenues.  Assume the graph shows that a 30% tax rate and a 70% tax rate will generate the same revenue.  There are some who would prefer the 70% rate because it would make the wealthier pay a bigger share of the bill.  Why would we care whether the rate is 30% or 70% if it generates the same dollar revenue?

The answer is that the 30% rate will support a larger growing economy, more innovation and startups, and lower unemployment.  If we can choose from two rates why not choose the rate that is much more likely to generate a robust growing economy?  It is not a matter of wealthier people generating more wealth that trickles down. It is a matter of stimulating a wider distribution of wealth generating activity.

The first objective is to find the rates that generate the most revenue, but possibly even more important is to find the tax rate that supports the most robust and growing economy.

We must also distinguish between statutory rates and effective rates.  The statutory rate is the scheduled bracket rate but the effective rate is the rate paid after deductions.  Effective rates have fallen much less sharply than statutory rates.

Deductions give the government an opportunity to direct tax cuts to their preference.  Tax deductions for mortgage interest, for example, became one of many factors that contributed  to the glut in housing supply we now face.  The real power of politics is often exercised in the granting of tax deductions.

Equally important to the distinctions between statutory and effective rates is the understanding of marginal tax rates.  What affects economic activity and growth is not the total or average tax rate but the tax burden on the next  (marginal) dollar of income.  In the 1970’s inflation pushed people into higher tax brackets.  The combination of a higher rate with less purchasing power was exceptionally devastating to economic growth.  This is another reason why the control of inflation was as critical to Reagan’s  success as the reduction in friction costs.

The term ‘supply side’ is less descriptive of the theory itself than the fact that it was offered as an alternative and a critique of Keynesian economics which was focused on demand stimulation.

While supply side theory is most commonly associated with Arthur Laffer and the Laffer curve, the theory was not of his origin.  He was noted for the simple bell curve he drew on a napkin for Donald Rumsfeld and Deck Cheney in the 1970’s.  The principle author was Robert Mundell, who won the Nobel Prize in economics.  In his acceptance speech, A Reconsideration of the Twentieth Century Mundell applied the theory throughout recent history.

In 1924 Calvin Coolidge gave a speech that showed his understanding of Mundell’s principle long before the name ‘supply side’ was ever applied to it.

The Laffer Curve applies to taxes but it is really a consideration of all friction costs. Government mandates and regulations that also burden production must be considered.  Milton Friedman noted the Permanent Income Theory which basically noted that one time stimulants do little because consumers and investors will only respond to how their continuous and permanent income is impacted.  I contend that our tax laws have been so inconsistent and erratic that whatever impact they may have in theory are negated by a simple lack of trust.

Theories are explained in a vacuum, but in application there are other factors that must be considered.  Because of this,  tax cuts alone will have limited impact if they are accompanied by growth in other friction costs.  There are other factors such as overall debt, foreign competition, and the existing economic environment that will either facilitate or obstruct the impact of economic policy.

But the best statement on supply side may have come from one of the comments on my article posted by a reader at American Thinker:

The left loves to obfuscate the language.  Let us un-obfuscate it:  “supply-side economics” is simply “economics”.  It is the way the world works.  It’s known, it’s proven and it’s real. Anything else, whether it is called “Keynesian economics” or “stimulus” or “priming the pump” or whatever specious buzzword the “intellectuals” call it today, is just smoke and mirrors.  Stimulus has never worked — unless the goal is to destroy an economy and enrich and empower a small cabal of tyrants.

In recent news headlines:

• San Francisco will have a ballot initiative to ban circumcision.  While one could make an argument for this on other grounds those who support this initiative have used a comic book format featuring a blond muscled caped superhero named Foreskin Man fighting the evil moyels (the one who performs the circumcision) and rabbis who are displayed in graphic evil Jewish stereotypes entirely reminiscent of the most offensive anti-Semitic propaganda of the Nazis in the 1930’s.
• In Scotland,  West Durbantonshire banned books by Israeli authors. To their credit The Scottish Government and the Scottish National Party have spoken out against this action by one of their towns.
• In the Netherlands the Dutch parliament is debating a bill that would ban kosher slaughter on humanitarian grounds.
• Delta Airlines has signed a deal with Saudi Arabia partnering with their airline. This move would require Delta to ban Jews or those holding Israeli passports from entering Saudi Arabia on their planes.

I am reluctant to adhere to the paranoid Jewish stereotype that sees anti-Semitism lingering on every word, and an anti-Semite around every corner.  Yet  I must wonder what other people, what other country or what other religion is faced with such blatant affronts.  Can we imagine the outcry if a Muslim was banned from entering a country, if a gay was banned from getting on a plane going anywhere, or if books were banned from any other country or religious group?

The irony that Israel is the most tolerant of women, gays, and religious minorities of any country in the Middle East seems lost on those who seem to be unable to tolerate such a tolerant country.  If the point is to disassociate from oppressors, have any of them noticed what has been going on in Darfur for the last several years, or Libya and Syria in the last few months?  Have they noticed which direction the missiles are flying between Gaza and Siderot?

In a world that has become stiflingly politically correct there is only one bigotry still permitted without a public outcry.  It is time for that to change.

Over the years of writing this blog there are a few issue that the reading and analysis keeps returning to.  At the risk of repetition a few of them are:

• Political leaders have a natural tendency to promise benefits without paying for them.
• Personal virtues can become public vices. Charity that is voluntarily contributed is a virtue.  Money that is forcefully extracted, regardless of the intent, to give to another, regardless of need, is theft.
• Government can provide any benefit; it must only decide how to pay for it.  Taxes, debt, or inflation are the options.
• Government runs on political self interest. The market runs on economic self interest. Both will have failures. The benefit of market approaches is that economic self interest corrects mistakes quicker.  The answer to government failure is often more government.  Failure is thus perpetuated until drastic changes, frequently revolution, is invoked.  Our experiment has delivered drastic changes and survived drastic shocks largely without revolution.  (Once could label the Civil War a failed revolution.)
• Our dissatisfaction with government comes from depending on them to solve too many problems. While the debate focuses on taxation the bigger problem is less how we tax or how much we tax; it is how big we allow the government to become relative to our ability to support it.
• “ Magical power, technology or political power does not save us from our faults, but instead amplifies their ill effects.”
• “One should not confuse a problem to be solved with a fact to be accepted.” – Shimon Peres

The free market is not a creed or an ideology that political conservatives, libertarians, and Ayn Rand acolytes want Americans take on faith.  The free market is simply a measurement.  The free market tells us what people are willing to pay for a given thing at a given moment.  That’s all the free market does.  The free market is a bathroom scale. We may not like what we see when we step on the scale, but we can’t pass a law making ourselves weigh 165.  Liberals and leftists think we can.

The free market gives us only one piece of information, but it’s important information.  We ignore it at our own peril, the way the leaders of the old Soviet bloc did.  They lost the cold war not just because of troops or tanks or Star Wars missile shields.  Even Reagan and Thatcher couldn’t win the cold war by themselves.  They needed allies.  And the allies were Bulgarian blue jeans.  The Soviets lost the cold war because of Bulgarian blue jeans.  The free market was attempting to inform the Kremlin that Bulgarian blue jeans didn’t fit, were ugly and ill-made, and nobody wanted them at any price.  People wouldn’t wear Bulgarian blue jeans- literally not to save their own lives.  But the Kremlin didn’t listen.  And the Berlin Wall came down.

From Don’t Vote- It Just Encourages the Bastards by P.J. O’Rourke