Mechanics of Growth Jude Wanniski April 4, 1997

Supply-Side Economics Lesson No. 17

Memo To: Website students
From: Jude Wanniski
Re: Mechanics of growth

A new student, Robert Kingshill, has a difficult time grappling with the mechanics of taxation and growth, or I am just not as clear as I should be as a teacher.

Q: As long as we may either spend, save, or invest any proportion of our wage, salary, or capital gains income, what rationale is there for taxing them differently? A banker or broker doesn't care which is which. Who knows how much capital gains income is spent and how much wage and salary income is invested?

A: All growth is the result of risk-taking. Unless you reduce the barriers to risk-taking or increase the rewards to risk-taking, you cannot increase the economy's rate of growth. The only way to get a capital gain is to put after-tax labor income at risk. Only those whose risks are successful get a capital gain. This is why people like Alan Greenspan say there should be no tax on a capital gain, because it is the very worst way to raise revenue. If several.people are competing to build a better mousetrap, it is more likely a better mousetrap will be built. As you reduce the rewards to capital available to mousetrap improvements, the competitors drop out. If the rewards are reduced and the risks increased enough, all risk-taking will cease in the private markets. Government then will have to step in to take over the risk-taking role, a process known as socialism.

Banks cannot lend more capital than they can assemble through an expansion of depositors who have surplus labor income. The surplus labor income expands as more mousetrap companies have the capital to hire labor and compete for the prize, which includes a capital gain for the investor. It is not really possible to think this through anecdotally, though. This is why Adam Smith spoke of the invisible hand. When you add more capital to the entire system, the labor/capital ratio changes, which is why wages rise as do living standards. If you would like to pursue this further, I would welcome an exchange.

Q: Thank you for your reply. I have no quarrel with anything you said. But it doesn't answer why it is desirable to eliminate income taxes on capital gains income which is spent, but not on wage, salary, and corporate income which is invested. If capital is money which is saved or invested, but not money which is spent for nonbusiness purposes, then calling capital gains income which is so spent 'capital,' is erroneous. And if you don't know how it will be used, why tax one type of income differently from another? Unless it can be demonstrated that capital gains income is mostly reinvested and other forms of income are mostly spent, then why advocate reducing or eliminating taxes on one kind of income only rather than advocate reducing taxes on every kind of income by reducing or eliminating government subsidies, entitlements, borrowing, bureaucracies, and pensions?

A: Remember your labor income first has to pass through a tax gate before you can deal with what is left. You can spend it, save it in fixed-income securities, or invest it in equities. This is what I meant when I said a capital gain is only possible if you put after-tax income at risk. If capital gains are taxed, some disposable-income decisions are shifted to fixed-income, lower-risk securities, or to more consumption, or to a decision to work less. If you want after-tax income to be directed at equities, you must reduce the risk of investment or increase the reward to successful investment, or both.

Q: You say that "If you want after-tax income to be directed at equities, you must reduce the risk of investment or increase the reward to successful investment, or both." If you want capital gains income to be directed at equities, rather than used for consumption, then advocate revising the tax code to eliminate taxes on profits from investment in equities ONLY WHEN REINVESTED again in equities, in a manner similar to the way taxes on profits from selling your house are avoided when used to buy another house of greater or equal value. Otherwise capital gains income which is not reinvested should be taxed like any other income. This might make markets less volatile by encouraging investors to stay in rather than get out completely. You appear to advocate eliminating the capital gains income tax indiscriminately, but maybe we're getting closer to an agreement.

A: For some reason, you have an impossible time trying to figure out what I am saying. No matter how much I make the case that capital gains should not be taxed as ordinary income because it is not ordinary income, you continue to want to tax it as ordinary income. Your latest shot argues that as long as a gain is reinvested, it doesn't have to be taxed, but when it is realized, it should be taxed as ordinary income. I ask you why, when it is not? You say it should,  just because you want it to be. There is no point trying to cross that bridge.

Q: Please be patient with me a while longer. If we quit now, our time will have been wasted. There appears to be something important about the origins of capital gains which you take for granted and which I'm  overlooking. Perhaps part of it is definitional. Ill tell you how I believe economies work, what your words mean to me, and ask questions, and you point out when I go wrong. I'm a little simple-minded, so assume the following occurs in the past when there was no income tax: Since the wealth of nations isn't the money printed by their governments or the credit they may extend, I presumed what you meant by growth was a nation's people performing more services and making more products than in the past. Labor gets paid, sometimes in cash but mostly by checks, which are then sometimes cashed and spent or else are deposited in banks, and sometimes some is saved. If it is all spent on services or products by others, then labor is rewarded by other labor and money acts merely as the intermediary. If some is saved, then the marker for services or products is not all called in, and if consumption is delayed indefinitely, services or products may be devoted to tasks other than merely sustaining life. Suppose a bank risks some of the labor income deposited by loaning it to build a factory and gets paid back with interest, which is shared with depositors. Doesn't the interest earned in this case meet your definition of capital gain, namely, a gain from labor income put at risk? Now suppose that the laborers put part of their income at risk by betting on horse races. Winnings would qualify as gain from labor income put at risk, but, unlike the factory example, they wouldn't come from growth, as defined above, but from the losings of others. Is this distinction important?

A: Sorry I was short with you, but I decided to see if you would work harder at posing your questions. We'll try again with this new approach you suggest:

1. You presume that what I mean by growth is "people performing more services and producing more goods than in the past." We should clear this up first. Growth occurs when the economy utilizes its productive resources more efficiently in the creation of consumer goods and services that can be used within the economy or traded for the goods or services produced by another economy. An economy is working at the peak of efficiency when everyone who wishes to work can do so at the peak of their own efficiency. Growth doesn't occur when people cannot afford to hire carpenters to build houses or because their after-tax income goes to pay lawyers, accountants, bureaucrats, and jailers. An economy that is growing at the maximum can then only grow faster with either the addition of population or improved technology. By improved technology, I mean any idea that enables a unit of production of old products to require less human labor, or a new product to come forward to improve the living standards of the people. The United States is operating at much less than the official statistics, which advise we are at about 83% of capacity. My guess is that if we could covert the unemployed and underemployed, plus prisoners, drug dealers, lawyers and accountants into carpenters, composers, poets, teachers, doctors and nurses, we could quickly double the meaningful output of the economy. Remember, this is supply-side economics we are teaching at this website, not demand-side macro-economics. Macro-economics, which is practiced by all Ph.D. economists who advise the government, define growth as any increase in the volume of goods and services. This is why up until the very last gasp of the Soviet Union, the CIA was advising that its production was rivaling ours. An economy like Haiti's is operating at no more than 10% of its current capacity, by which I mean it could grow at double-digit rates for many years until it approached our 50% capacity level.

2. You first correctly state that "money" is not wealth, or the government could create wealth by printing money. Then you introduce money as wealth, when you state that when money acts as a medium of exchange in the spot market, it merely acts as an intermediary. You then assert that if the money labor receives is savedy money can be devoted to goods or services that go beyond simply sustaining life. This is not correct, Robert. All goods produced are exchanged for other goods in a very short period of time. When a baker bakes a hundred loaves and can only consume 50 in a day (exchanging them for other goods and services in the spot market) he must trade the other 50 for debt or equity. The folks who give him the paper claims then consume the loaves. The modern industrial and money economy can not be compared to primitive economies in which grasshoppers consume and ants save. Once again, all production is consumed. The saving concept is only a bookkeeping device that has evolved with modern banking and finance systems.

3. Interest earned on after-tax income deposited in banks is not a capital gain because it is not put at risk by the depositor in any meaningful sense. The bank and the depositor agree on the interest rate, which counts as ordinary income to the depositor. It is a cost of doing business to the bank, which deducts it from its profits. It is the shares of the bank which earn capital gains if it is wise in its bidding for money, which is put at risk. If the bank pays dividends to its shareholders, they pay income tax. If they retain the profits after paying corporate tax, keeping them at risk, the price of the shares may rise if the market believes the bank will be superior to its competitors in placing the funds at risk.

Betting on a horserace with after-tax income is a way of combining business with pleasure. You are of course right in saying the winnings are paid out of losings. But much the same happens in the wider economy, where most businesses fail in the first years of their activity. Do people get pleasure and real product out of paying a lawyer to help defend against government or private predators? The real product horseplayers get is the pleasure of the race and the increase in wealth that comes from the losers who get only the pleasure of the race. Some people get great pleasure in baking far more loaves than they or their families could ever consume, so they could give them away for the pleasure of being philanthropic, or to curry favor with the gods.

I hope this gets us further along in understanding the supply-side mechanics of wealth creation.