We are all very well aware of the debate going on over the space that tax and economic policy overlap, and the argument over whether Tickle Down/Supply Side economics is the boost in the arm that our economy needs.
Trickle Down/Supply Side economics is the idea that if top earners are taxed less, they will invest more in business infrastructure and equity markets (indirectly creating jobs and demand for goods and services) or employ more people (directly creating jobs and demand for goods and services). The theory goes that these objectives (job creation & investment) require significant resources and by taxing the wealthy less, they are left with more resources by which to do these things.
Supply Siders, in the context of the United States Economy, are conveniently ignoring one of the most important basic fundamental economic ideas. This idea is taught early on in economics because of it's relative importance and because almost all other economic ideas use it as a foundation. That idea being: opportunity cost.
Opportunity Cost is the principal that the true cost of something is not the nominal price you paid for that thing, but the value of all the resources expended to obtain that thing including the value of the next best alternative that was forgone.
In the context of Trickle Down/Supply Side economics, the proponents of such a scheme suggest that if they had a lower income tax rate, then they would invest in business infrastructure and jobs. However, a lower income tax actually increases the opportunity cost of investing in business infrastructure and jobs.
To elaborate, suppose Spacely Sprockets (an LLC wholly owned by Cosmo Spacely and that enjoys pass through taxation due to their LLC status) made incremental gross profit above his expenses of $10 million last year. (Translation: Spacely Sprockets made an additional $10 million in net income above and beyond the normal net income).
Mr. Spacely has a few choices here. He (the firm) can:
1. Pass the money on as net income, of which a portion of it will then become due as income taxes
2. Use the funds for new capital investment for Spacely Sprockets, in order to expand the capabilities of the firm in the future
3. Use the funds to hire new employees, in order to expand the capabilities of the firm in the future.
When looking at the choices Mr. Spacely faces, we see the source of the "Tickle Down" theory: "the less taxes Mr. Spacely has to pay in (1), the more money has has for (2) and (3)." However, this ignores the reality that (2) and (3) would occur before (1). Capital expenditures and payroll expenses are tax deductible and aren't effected by the tax liability when any residual funds are passed on as net income.
In fact, the lower the tax rate, the more expensive, in Opportunity Cost terms, it becomes to do (2) or (3). Let's look at examples of what the opportunity cost of (2) or (3) are at different tax rates.
Scenario A: 0% Tax Rate.
If Mr. Spacely faces a 0% income tax rate, then every $1 he spends on (2) or (3) is a full $1 he does NOT get to keep personally. At a 0% tax rate, the opportunity cost of capital investment and job creation is 100% of the amount the tax payer would have been able to keep.
Scenario B: 25% Tax Rate.
If Mr. Spacely faces a 25% income tax rate, then every $1 he spends on (2) or (3) reduces the amount he gets to keep personally by $0.75. The opportunity cost of capital investment and job creation is lower than in a scenario with 0% taxes.
Scenario C: 50% Tax Rate.
If Mr. Spacely faces a 50% income tax rate, then every $1 he spends on (2) or (3) reduces the amount he gets to keep personally by $0.50. The opportunity cost of capital investment and job creation is lower than in a scenario with 0% or 25% taxes.
Scenario D: 100% Tax Rate.
If Mr. Spacely faces a 100% income tax rate, then every $1 he spends on (2) or (3) reduces the amount he gets to keep personally by $0. There is no opportunity cost for capital investment or job creation, because Mr. Spacely doesn't get to keep that money either way.
For reasons that should be obvious, Scenario D isn't preferable because then there is no incentive to make additional income, since the proprietor wouldn't benefit from that extra work (though he could pay himself a higher salary, but we won't get into the weeds there and we'll just assume that isn't an option).
The part of the tax code that makes capital investment and job creation attractive is that these are pre-tax expenses. Lowering the income-tax rate doesn't provide economic incentive to hire more or invest in more capital, in fact it just raises the opportunity cost of doing so. The tax code was set up this way (with capital investment and payroll being tax deductible) specifically for the reason of incentivizing this kind of behavior.
Trickle Down does work in a scenario where investment and employment expenses are NOT tax deductible, but I've yet to see anyone make the argument that they shouldn't be.
To best incentivize capital investment and job creation, the income tax rate should be set at the rate which the opportunity cost is roughly equal to the rate of return earned on new investment/job creation.
Trickle Down and Supply Siders made a major gaffe in the formulation of their theory (which has empirically failed to "trickle down" each times it's been used, resulting only in increased income inequality)l and it deserves to be called out.
For real capital investment, and real job creation, you need a tax code which increases the opportunity cost of these things so that investing business structure and creating jobs is the best use of funds.
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