Signs of debt crisis strain are everywhere these days.  Despite over $14 trillion in US debt, the Left is calling Republicans extreme for wanting major cuts.  On the other hand, Obama has no written plan but is acting like a born-again deficit hawk going after corporate jets.  Even better, some are touting the bonuses of hedge fund managers as a tax gold mine.  The latter sentiment is yet more proof that politicians on the Left just don’t get economics – at all – and also highlights one of America’s worst problems.

For those that have been following, it turns out that certain bonus income of money managers is taxed at a 15% rate (like dividends) instead of potentially 35% (like ordinary income).  The tax laws allow for that lower rate if they hold onto the bonuses for a certain period of time.  Non-Real World politicians and economists are crying foul – asserting it is unfair they get that break – and claiming that as much as $20.7 billion could be collected if that loophole is done away with.

Such is the state of “good enough for government” thinking.

You see, Non-Real World politicians and economists see the world like a calculator: change a tax rate and collections rise.  In the Real World, human behavior adjusts to laws that change – sometimes dramatically so when it involves taxes. Just ask American Founder and Supreme Court Justice John Marshall who stated that “the power to tax involves the power to destroy.”

Take the 1920’s for instance.  The Democrats had increased the top marginal tax rate to over 70%. That increase greatly diminished or nearly “destroyed” incentives for individuals.  Indeed, Secretary of the Treasury Andrew W. Mellon noticed that rather than taking risks with their capital, capitalists were parking their money in tax-free government bonds.

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A former reporter for the New York Times, Fox Butterfield, became a bit of a laughingstock in the 1990s for publishing a series of articles addressing the supposed quandary of how crime rates could be falling during periods when prison populations were expanding. A number of critics sarcastically explained that crimes rates were falling because bad guys were behind bars and invented the term “Butterfield Effect” to describe the failure of leftists to put 2 + 2 together.

We now have a version of the Butterfield Effect in tax policy. Recent IRS data show that rich people earned a record amount of income in 2007 and also faced their lowest effective tax rate in almost two decades. Proponents of soak-the-rich tax policy complain about these developments, but they seem oblivious to the Laffer Curve insight that rich people earned more income in part because tax rates were lower. This video explains how the Laffer Curve works.

Liberals don’t understand that if they penalize the rich with higher tax rates, as President Obama is proposing, they will be disappointed to discover that they collect considerably less revenue than predicted for the simple reason that wealthy taxpayers will respond by earning less taxable income. This Bloomberg excerpt is a good example. The leftist quoted in the article assumes that income is a fixed variable and successful taxpayers will passively endure higher taxes.

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