Comparative Economics Jude Wanniski July 11, 1997

Supply-Side Summer School Economics Lesson #4

Memo To: Website students
From: Jude Wanniski
Re: Comparative Economics

The New Republic weekly magazine has been an opponent of supply-side economics through the entire course of the Reagan Revolution. It has been especially antagonistic to the idea of cutting the capital gains tax. In today’s lesson, we offer an exercise that dismantles its July 7 editorial on the subject piece by piece, to show where they are coming from and how their arguments can be handled. Their new editor, Michael Kelly, is not as religious in his opposition as previous editors have been. My assumption is that he did not write the editorial, though, but that he may have assigned it to Jonathan Chait, who wrote the cover story on me that you can get to from our home page. The lesson is in the form of a long letter to the editor:

Letters Editor
The New Republic
1220 19th St., NW
Washington  DC   20036

Dear Editor:

 Your July 7 editorial, “Capital Loss,” makes all the right arguments against cutting the capgains tax, but in a demand model, in which the correct management of aggregate consumption determines economic growth. In a supply, or production, model (which your editors for the past decade have refused to consider), the only correct tax on capital gains is zero. This is why Federal Reserve Chairman Alan Greenspan has said it is the “worst possible tax by which to raise government revenue.” I’d like to go through your editorial line-by-line, to show you its fallacies.

1. You say capital gains are the “income from the sale of assets like stock.” A capital gain is actually a rise in the value of any asset that has been acquired with after-tax income. A capital gain can only occur through the investment of after-tax income. It is not accurate to call a capital gain “income.” Indeed, the argument for taxing a capital gain is generally couched in terms of treating a capital gain as ordinary income. The technical distinction is most important, as income is not the same as wealth, which is what is left after taxes are paid on income. A capgains tax is a tax on wealth, not income.

2. You are scrupulously fair in inferring that if a capital gains “break” generates greater overall wealth you would not necessarily reject one. But you go on to say “The capital gains break divvies up the economic pie less equally without increasing its size.” This assertion is at the heart of your opposition. It ultimately rests on an assumption that the economic pie cannot be increased by increasing the after-tax rewards to risk-taking.

3. You argue that when “the government tries to dictate what people should do with their money, it distorts the free market, sometimes in unsound ways.” You argue that if the capgains tax rate falls to 20%, rates on ordinary income and bank interest will still face tax rates of up to 39.6%. You say: “With such a disparity, people will be more tempted to sink their money into less economically useful investments just to get the tax shelter.”

A. The tax on ordinary income precedes any possibility of a capital gain. A capital gain can only occur through the investment of after-tax ordinary income. Ordinary income has no risk associated with it. You work, you get paid.

B. Bank interest is not associated with risk. It can be taxed at ordinary rates without causing a decline in economic growth as long as the ordinary rate is not high to begin with. Whenever after-tax income is saved on the promise of a fixed rate of interest, it should not be considered as the equivalent of an investment in equity, which has no guarantee of any return.

C. We want people to sink their money into investments which may not turn out to be economically useful as long as they bear all the risk. They could, after all, consume that income instead of putting it at risk with an enterprise that has no collateral and thus cannot borrow against assets. You are misinformed when you characterize a differential on capital gains as a tax shelter. A tax shelter is a place where you can buy a financial instrument that guarantees you can avoid tax liabilities on ordinary income by incurring tax liabilities greater than your income. There is never a guarantee of a capital gain and thus it can not be considered a tax shelter. Young journalists who write capital gains editorials should be urged by editors to check their work with non-partisan tax lawyers.

4. You say in the next line “Exactly this happened in the 1980s, when investors poured billions into constructing empty office buildings in order to take advantage of capital gains incentives.” The assertion is pure nonsense. It is not possible for an investor to be enticed into building an uneconomic asset which will not hold its value, let alone collapse in value, because of a capital gains incentive. Your editorial writer displays inexperience in finance and thereby devalues the product of the magazine. You should consider hiring some one person who understands these technical details, so that the foundations of your policy recommendations are not so seriously flawed.

5. You say: “Expanding the capital gains break will mean that, instead of following the dictates of the market, investors will increasingly follow the dictates of the tax code, which makes for a less efficient economy. Republicans usually find such results troubling when the beneficiaries of market meddling don’t include their own constituents.” This observation shows a flawed understanding of the market’s function. The market is only efficient in allowing capital to flow to uses that on balance will produce a positive after-tax return. If government decides to have no capgains tax on wildcat exploratory oil wells, more capital will flow to areas likely to produce a positive return which would produce negative returns if the capgains rate were 28%. The market will not finance oil exploration in areas not likely to produce oil, tax or no tax. You have a perfect right to criticize Republicans for wishing to target capital flows to favored constituents, just as Republicans have a right to criticize Democrats who wish to target their constituents. The cut to 20% for all classes of assets does not favor any constituent. It favors only those who wisely choose the best places to invest, knowing as many investments will fail as will succeed.

6. Then you assert: “So manipulating the tax code, in general, slows economic growth.” Sorry, you cannot make that assertion, as it flows from a series of flawed definitions and assumptions.

7. Then you say “this particular manipulation of the tax code is especially ill-conceived. According to capital gains aficionados, lowering the tax rate on capital gains would encourage people to invest their money rather than spend it.” This is incorrect. The intent is not to get people to invest their money rather than spend it. You go on to say “Businesses would use that money to buy new equipment or start new ventures, and the economy would grow faster. The key here is that the capital gains break is simply a way to boost investment.”

Wrong on all counts. Most people do not have leeway in their ability to save rather than spend, and a decrease in spending in itself suggests new investment will have a smaller market into which their products can be sold. You are here criticizing those advocates of a lower capital gains tax who see the world in a demand-side framework. The intent of a lower capgains rate in the supply model is to encourage people who can increase their production to do so, in order to acquire equity in exchange for their goods and services, instead of debt. The supply-side aim is to have capital flow to people who do not have it, and do not have assets to collateralize. You say businesses would use that money to buy new equipment. What really occurs is that new production comes into the market, not new money. The capital gains break is not simply a way to boost investment. It is a way to cause unutilized capital to come forward and be put at risk. It could mean that the capital will flow to private equity instead of government debt, but the private economic growth which would occur would cause tax revenues to rise in replacement of the government’s need to borrow.

8. You argue that in order to understand why a lower capgains tax rate is an ineffective way to boost investment, we should consider the possible responses. “Some people will decide to put their money into the stock market instead of buying a new convertible. That boosts investment. Other people will move their savings from something that’s taxed as ordinary income, like a bank account, into something that is taxed at a lower capital gains rate. That has zero effect on investment. Still other people will be putting aside money until they’ve reached a specific amount -- for retirement, say, or their children’s college tuition. Expanding the capital gains break will allow them to reach their goal faster -- the money they would have devoted to taxes would go into their mutual fund instead -- and hence induce them to invest less. This would reduce investment.”

A. Investment instead of purchasing a convertible: This does not boost investment at the macro level. If the convertible is not purchased, investment in the auto industry will have a lower return and investment will not be boosted.

B. Moving money from the bank account to lower capital gains vehicle: You say this has zero effect, but in fact has a positive effect. Capital put at risk will produce greater returns to the economy than capital saved.

C. I’ve not heard this fallacious argument for more than 20 years. I identify it with Herbert Stein, who was President Richard Nixon’s chief economic advisor. He is the man who persuaded Nixon to raise the capgains tax in 1969 -- which ultimately led to the collapse of the economy and Nixon’s impeachment. Stein believed that people have a wealth target, which they reach by accumulating after-tax income. That is, if you tax them at higher rates, they will work even harder to reach their goal. This is equivalent to the argument that Japan had faster growth rates after WWII because it was bombed out, and had to work harder to rebuild. The solution for a recession is to drop bombs on the economy.  Economics is the behavioral science aimed at producing more with less effort, i.e., economizing on labor. The idea of withdrawing capital in order to require more labor is not one The New Republic should be embracing.

9. From your preceding argument you conclude: “Thus the total effect on private investment would be close to a wash. Some people would invest more, others less, and most would do nothing different. This is an indirect, tiny, uncertain effect. But the capital gains break also does something else that wields a direct, huge and very certain effect on the investment rate: it increases the deficit. Every dollar the government must borrow is one less dollar available for private investment. A lower capital gains tax rate means less tax revenue, higher deficits and more government borrowing from investors. Whatever droplet it may encourage people to add to the pool of investment is dwarfed by the tidal wave it forces the government to take out.”

The conclusion from specious assumptions that a capgains rate cut would have only indirect, tiny, uncertain effects is an unsupportable assertion. In his Senate Banking Committee testimony early this year, Greenspan noted that a zero capgains rate would almost surely pay for itself at once, with the effects it would have on economic growth throughout the entire economy. That is, if only a tiny addition to GNP growth, one-tenth of one percent, would increase federal revenues by $35 billion annually, with significant rises in state and local revenues. The capital market, remember, does not care from which spigot capital flows into the general pool. As all governments in aggregate would be selling fewer bonds, given aggregate revenue flows, the capgains cut would be adding to the resources available to the private sector. This is true even in a static model. In a dynamic model, which I will not ask you to accept, the flows are much greater. Your assertion that as it may add a droplet of capital while government loses a tidal wave of capital is an argument I have never heard, even from the fiercest opponents of a capgains rate cut. Because you are editorializing, not reporting, you are of course free to make off-the-wall assertions to bolster your case. Would you care to cite an economist in the Clinton administration who would back up your assertion? Any one will do.

10. “Advocates of cutting the capital gains rate frequently argue that it actually increases tax revenue. Their evidence: in the past, capital gains revenue has risen after the rate has been cut. But this proves nothing. If the government offered a break to people with tattoos, so many more people would get tattoos to qualify for the lower rate that revenue from people with tattoos would rise. That still wouldn’t mean that a tattoo tax break would bring in more total revenue.”

I’m at least happy to see you acknowledge that a lower tax rate on something produced, a tattoo, will increase its attractiveness in the market. There is a behavioral response. The flaw in your argument is that a tattoo is an item of consumption and we are talking about increasing investment. If we increase the after-tax income of people with tattoos, we will only get more people with tattoos. If we increase the after-tax reward for people who are now refusing to put their after-tax capital at risk, we unambiguously will get more investment, either from those who now are holding back their productive capacity because of insufficient reward for the risks involved, or from those who are putting their surplus production into low-risk savings, i.e., government bonds.

11. “Finally, a special tax rate for capital gains income is not only bad economics. It is a moral outrage. The effective tax rate on capital gains income, counting all the special loopholes and breaks, is 7 percent. Trust fund beneficiaries are paying a much lower income tax rate than auto workers, and that gap is about to widen. Because Clinton gave in so quickly, the Republicans haven’t been forced to defend this publicly. Somebody ought to make them.”

Well, good for you. Your editorial forced me to contest your arguments. If you wish to continue, by contesting mine, I would be happy to keep going until we have a meeting of the minds. Moral outrage is no argument, though, especially if your outrage is based on faulty economics or faulty reasoning. The argument that trust fund beneficiaries pay a lower rate than auto workers is only true because most trust funds have been appreciating in the bull market and are now solvent. Prior to the Reagan years, most trust funds were insolvent, marked to market, including the pension funds of the auto workers. It was the Reagan tax cuts that sent the stock market and the bond market soaring, which put the trust funds above water. Unhappily, the capgains rate was increased in 1986 and left unprotected against inflation. A cut now would have the effect of increasing the real wages of the autoworkers, by adding capital to their labor. It would also increase the value of trust fund investments, to the benefit of auto workers who will retire.

[To Supply-Side students: Now that you have read the above, you should read it through again, think about what you’ve read, and read it a third time. The editorial writer for The New Republic is clearly trying to grapple with arguments he has heard, but does so from a demand-side framework. Chances are that you are also in a demand model, as your adult lives have been lived in that universe. It is very hard to completely get out of one mindset into another. This is why the exercise presented here is so useful in comparing the two right next to each other.]