There are two things that contribute to economic growth in the world — two ways to make money. They are labor and capital, labor being the amount of time that people give up to produce a good or service, and capital being the money that is used to buy the things — machines, buildings, raw materials, etc. — that are used. Both are necessary for economic growth.

The amount of labor or investment capital that a person will supply to a business is based on two things: the amount that the business will pay them for it — called a wage in the labor market and an interest rate or shares of stock in the capital market — and the amount of profit that the labor or investment capital can make for the business. I’m sure you will agree that this makes perfect sense. A person won’t supply labor or capital if they aren’t getting enough in return, and a business won’t buy labor or capital if it costs too much to get it.

Another important attribute is the relationship between the amount of labor/capital purchased and how much it’s worth to each party. To a business, each unit of labor purchased is worth less than the last. For example, a business with only one employee will have that employee do the most important — aka most profitable — job. If they hire a second employee, that employee will do the second-most profitable job, etc. It works the same with capital. The first capital received will be used in the most profitable way, with each unit of capital becoming less profitable than the last.

On the other hand, to a person contributing labor, the first unit of labor they supply is the least valuable. For example, a person who works one hour per day may only be giving up watching another hour of T.V. to go to work. But if that person continues adding hours, they will give up more and more important things, so you can see that each hour is more valuable to that employee than the last, and thus, the employee would require additional per hour compensation to be willing to work the extra time.

To a person contributing investment capital, it works the same. The first dollar they give up would probably have only gone toward the purchase of unnecessary luxuries. But as investment progresses, more important things must be given up. For example, giving up your last dollar may reduce the amount of food you can eat, and therefore would be very, if not infinitely, valuable to you, and you would have to be compensated accordingly — through excessively high interest rates or a considerable share of a company — to give it up.

In economic terms, this means that the price of labor and capital demanded by businesses slopes in the downward direction as the quantity increases, and the price of labor and capital supplied by citizens slopes in the upward direction as the quantity increases.

Eventually these two lines, known as supply and demand, will meet. The price at which these two things meet is the price that will be set for the labor or capital, and the corresponding quantity is the amount of labor or capital that will be used. Again, this makes perfect sense if you think about it. The last unit of labor or capital purchased is the one where both parties agree that to trade anymore would be counterproductive: The business and citizen would be giving up more than they were gaining by meeting the other’s needs.

Although the last unit of labor or capital is an even trade for both parties, this is not the case with the rest of it. In the beginning, the labor and capital that are traded are making far more money for the business than what the business is paying. This is the business’s profit, otherwise known as the consumer surplus since the business is the one consuming the labor or capital in this case, and there is an additional, but smaller, profit — due to the downward slope — for each unit of labor or capital until it is no longer profitable for the business to continue trading.

To the citizen, however, the first unit supplied is the least valuable, which is why they gave it up first. The difference between what they would have been willing to sell their labor or capital for and what they were actually paid for it is the profit of the citizen, otherwise known as the producer surplus. Each unit sold gives less profit than the first until the trade is no longer profitable. Just like the business. The combination of the consumer and producer surpluses is economic growth. That is, it is the difference in the value of what you put in — labor and capital — and the value of what you get out — wages and profit. The higher this is, the more efficiently we are allocating our resources.  

What a tax does is increase the amount of money that the supplier — the citizen — requires before they are willing to trade. For example, if a citizen must give 25 percent of their income to the government, they would require a wage — or interest rate or stake in the company — increase of about 33 percent to make up for the tax. That way, when their income was taxed at 25 percent, they would end up with the same amount as they would have otherwise gotten, as 75 percent of 133 percent is about 100 percent.

Since the supplier is required to pay 133 percent of what they used to be paying, it will no longer be profitable for them to buy as many units of labor or capital. Remember, the amount of income from each unit is less than the last, so they will reach the point where it is no longer profitable to trade for labor or capital sooner than they would have if there was no tax.

There are three major effects of this: The first is that the profit of the business will be reduced. The second is that the profit of the citizen supplying the labor or capital will also be reduced. The third effect is that the income of the government will increase. However, the amount that the government will make is less that the combined total of what the business and the citizens lost. This is because less than the efficient amount of that business’ product is being produced.

Even though it is more profitable for both parties to allocate the resources of labor and capital to that business, it will not happen because the tax makes it unprofitable. This means resources are no longer flowing towards their most efficient use, which means the economy does not grow as quickly. This is the unintended effect of taxes many liberals, especially the ones working in government, are unfamiliar with.

Labor and investment capital are the two ways in which people make money. They either trade their time or their treasure. Those are both taxed: labor in the form of personal income taxes, investment capital in the form of capital gains taxes. Either way, the end result is the same.

The Democrats, in general, and Barack Obama, in particular, assert that the rich should be taxed more. However, when this happens, the rich, who supply the overwhelming majority of the investment capital — that’s why they’re rich, by the way: It’s difficult to make millions on wages alone — will not supply as much, leading to less economic growth and less overall income for the entire country. Remember, the businesses that are receiving this capital, which is almost always necessary for startup and often for growth, are the ones who provide jobs for everyone else.

If one business, through an increase in capital, is able to make more money per worker, some of that money will either go back to the worker who is producing it or to new workers who are now profitable to hire because the money the business will make by trading their wage for labor has increased. Either wages go up or employment goes up. Or, in many cases, both. And, since firms compete for labor, this tends to raise the wages of other firms as well.

President Reagan reduced the top income tax bracket from 70 percent to 28 percent and tax revenues over doubled. That’s right. The money the government made from the income tax increased because the economic growth caused by the drop in taxes vastly overcompensated for the lower tax rates.

It was the same when President Kennedy reduced the top income tax bracket from 91 to 70 percent. Kennedy, a Democrat, justified his tax cuts by saying:

“It is a paradoxical truth that tax rates are too high today and tax revenues are too low — and the soundest way to raise revenues in the long run is to cut rates now. Only full employment can balance the budget — and tax reduction can pave the way to full employment. The purpose of cutting taxes now is not to incur a budgetary deficit, but to achieve the more prosperous expanding economy, which will bring a budgetary surplus.

“Next year’s tax bill should reduce personal as well as corporate income taxes: for those in the lower brackets, who are certain to spend their additional take-home pay, and for those in the middle and upper brackets, who can thereby be encouraged to undertake additional efforts and enabled to invest more capital.”

Once upon a time, the Democrats understood too … But now Obama wants to raise taxes on the rich as well as the capital gains tax, despite the economic implications.