Low Tax Rates Will Generate Jobs As Well As Bring In More Revenue

In the current jobs debate, one simple economic truth is often neglected: Low tax rates produce more government revenue, not less, and allow more private-sector jobs to be created. Why? Low tax rates leave more capital in private hands to be invested in the marketplace.

As simple as this sounds, it's nonetheless often ignored by policy-makers. In short, capital in the hands of private entrepreneurs is invested, which is more efficient than giving it to the government to spend.

Not that job creation takes place at the same pace everywhere when rates are cut. Large corporations, small businesses (including individual proprietorships), and new businesses all create jobs in different ways and at different rates.

But the last two groups — small businesses and startups — are key because they create 70% of the jobs and will hopefully grow into the giant corporations of tomorrow. Lower tax rates, by giving incentives to entrepreneurs, foster the birth of the "new ideas" that make business creation possible.

New ideas are generated daily by thousands of people. To bring them to fruition, they need capital. Usually this comes from friends, family, and personal savings.

But the key here is that capital comes from savings, i.e. what is left after meeting family, business and, perhaps most importantly, tax expenses.

Funds The Big Ideas

Naturally those that earn large incomes save the most. They put their money to work by investing it, turning it from savings into investment capital.

This is where venture capital (VC) comes from. And it's responsible for funding most of the big ideas of the last 30 years.

Once an idea has been developed, funding is needed to build a viable business. Most new businesses are funded by venture capital — not by the people with the original idea. In general, venture capitalists seek a minimum net return on investment of 25%.

That return has to compete with municipal bonds, which yield about 5.6% historically, and every other investment in between.

But risk/reward isn't the sole consideration. Time, work, and effort involved in the investment are also factors.

Low risk investments such as low-yield debt require no work by the VC.

By contrast new businesses have a high failure rate, and require oversight, board meetings, travel, monthly arguments over business philosophy with management, and personal dealings with often very difficult, ego-driven CEOs.

It's an arduous affair, difficult work with very high risk. So why do it? The potential for superior returns.

In reality, most successful businesses achieve something comparable to large-cap stocks — historically, about 9.6%. So although a 25% net is the goal, few actually achieve this return. Such high potential returns help offset the risks of total failure.

The companies that meet this profile not only need new ideas, they need a credible business plan that includes pricing, expected revenue and even profit.

Business Killer

Because the price is determined by the market, any arbitrary influence on costs will influence the entire equation.

Consider the "Billy Mays"-like products sold on TV infomercials. They are nearly all priced at $19.99, and that price is not elastic. Market experience has taught that prices such as $20, $25 or higher do not sell nearly as well. So all the businesses are set up to fund, make and sell products in a price range they know will derive the most sales.

As such, a higher tax rate on the earnings of these Limited Liability Corporations, Sub-S Corporations and Limited Partnerships will raise the cost of making a product.

Because these companies are already working with competitively tight margins, higher tax rates kill both new ideas and the startup businesses that make them real if they push the final price above $19.99 — or do not let the VC net 25%.

The higher the tax rate, the fewer ideas are funded, and thus the fewer jobs get created. This ultimately generates far less revenue for the tax hungry U.S.Treasury.

The concept of "Risk versus Reward" is rarely (if ever) understood by politicians, bureaucrats or academics. They've never started a business.

Any tax that affects risk/reward also affects how capital is invested. A 100% risk for a 25% reward, vs. little to no risk for a 6% return, is the key comparison.

If you alter that comparison by lowering returns, the tradeoff becomes too great as the risk now outweighs the reward.

If the government put lower limits on credit card interest, many people would not be granted the credit cards, because the risk of nonpayment would outweigh the reward for the bank.

And if the government raises tax rates, many businesses will not get funded for the same reason. If the risk and reward do not balance, venture capitalists will not invest.

With years of experience, VC committees set guidelines, and they need to check the "25% box" as a matter of policy. If that box doesn't get checked, the deal won't get done. (Of course, there are always exceptions. A new Google, for instance, might still get seeded. But hundreds of thousands of low margin, small startups will not.)

Ludwig Von Mises summed up the dangers of capital taxes this way :

"If the methods of taxation ... bring about capital consumption or restrict the accumulation of new capital, the capital required for marginal employments is lacking and an expansion of investment which would have been effected in the absence of these taxes is prevented."

Translation: If you tax capital too much, you'll have less investment and fewer businesses started.

Under the Democrats' model of higher taxes for "the rich," venture capitalists and other investors will make far fewer investments. Ultimately, this leads to higher joblessness, which in turn will increase future deficits and reduce future GDP growth.

Envy-Based Policy

In the end, this leads to lower revenue to the U.S. Treasury. Thus, from a strictly fiscal standpoint, it is a self-defeating policy to raise capital taxes.

This is not the outcome that the Democratic administration promised when first they offered "hope" and "change."

Today the very future of the U.S. is on the line. Rather than basing fiscal policy on sound economic reality, our government is operating in the name of envy and the morally and prudently wrong notion that the "rich" can and should pay more.

Perhaps they can. But they can only do so at the expense of innovation and long-term job creation that a government-funded highway project can never replace.

In the end, the real danger is a socialist America, with state control of the economy and the redistribution of wealth as its goal.

In the newly elected Congress, let's hope that the leadership refocuses on a tax plan for America that will free private capital for job creation.

Otherwise it's time to prepare for a bleak future where "We the People" could very well become "We are all comrades now!"

• Sperandeo is a professional trader and money manager with over 45 years of Wall Street experience.