Mechanics of growth Jude Wanniski May 14, 1999

This is an adaptation of a Q&A lesson from the first SSU spring semester, which ran on April 4, 1997. At the time we had only 35 registered students. The Q&A has been altered enough that I've not included the name of the questionner, but we did cover some interesting ground and it is worth a replay as we near the close of the spring semester.

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. As fewer minds are put to the task of improvement, the chances of improvement decline. The loss is great to the economy as a whole because in one way or another, everyone in the economy shares in the improvement if it is found. 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 -- which is the process we know as socialism. Government of course can take successful risks, but only by financing individuals who are long on ideas and short on finance. The Manhattan Project that developed the atomic bomb comes immediately to mind.

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 really is not 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 along with living standards.

Q: 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: I suppose I'm not being clear enough, as you are having a difficult time understanding that capital gains should not be taxed as ordinary income because it is not ordinary income. It results from an investment of after-tax income that is put totally at risk, unlike investment in a financial asset that promises income in the form of an interest payment or a dividend on profit.

Q: Please be patient with me a while longer. 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. I'll 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. 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 saved, money can be devoted to goods or services that go beyond simply sustaining life. Not so. 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 horse race with after-tax income is a way of combining business with pleasure. You of course are 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 can give them away for the pleasure of being philanthropic, or to curry favor with the gods.

Q. What would you do now to encourage growth in the economy? Isn't it growing fast already, with unemployment down to its lowest level in many years?

A. As a matter of fact, I just came back from Washington, D.C., to help move along a bipartisan tax bill co-sponsored by Senators Paul Coverdell [R-GA] and Bob Torricelli [R-NJ]. The bill is called the Family Savings Act or the "small savers bill." It has been described in terms of demand-side economics, i.e., increasing "savings" to increase growth. In the supply model, growth must increase in order for savings to increase. Production = Consumption + savings. So for savings to increase, we should focus on the supply-side (production side) of the equation. The beauty of the Coverdell/Torricelli bill is that all its provisions have positive effects on the supply-side of the equation. If I were a wizard and say a few magic words to design a perfect tax code, I would write a different bill, but given the fact that Republicans and Democrats are barely talking to each other, and legislation that might make Republicans happier would be vetoed by the President, this bill provides the best possible platform for a tax cut this year that the President would sign.

1. It would provide for a $5,000 per year exemption on capital gains tax. The provision means little to the wealthy, but to ordinary people who would like to get wealthy some day, it has pure supply effects. At the margin, it increases production for the purpose of investment in financial assets, because a capital gain of this small amount would be tax free. Because there are so many ordinary people who would be further drawn into the production process by their small additions of capital, the total effect would be as great or greater than a small number of rich people increasing their willingness to produce with no assurance of a payoff.

2. It would provide for a $500 per year tax exemption on dividends and interest. To the degree rewards are increased for lesser risks, the value of all productive assets increase as well. With this type of tax cut, the risk structure for the entire economy does not improve as much per dollar as with a lower capital gains tax -- because a capgains tax can only tax success, while interest and dividends can be tax regardless of success. Given what we know about the other distortions in the federal tax code -- especially the excessive payroll taxation on ordinary workers -- there is little chance this exemption would have negative returns. There's a good chances its positive effects on production would yield higher levels of revenue than the "cost" of the exemption.

3. One of the nicest features of the legislation is that it widens the tax bracket between 15% and 28% by $10,000. This is another direct reduction of pressure on overtaxed workers, who would keep an extra $1,300 per year if their incomes move as high as the 28% rate. Because the budget is throwing off massive surpluses because of the excessive payroll tax -- designed at a time when it was assumed the economy could not expand as it has -- this widening of the brackets does have powerful supply effects.

4. There is also contemplated an increase in the annual amount permitted under the Roth IRA, named after Sen. William Roth [R-DE], chairman of the Senate Finance Committee. The Roth individual retirement account now permits an individual to invest $2000 a year in after-tax income and have it grow through interest, dividends or capital gains, with no tax at all when it is drawn down for retirement. Coverdell-Torricelli would expand upon this concept, which is an enormously powerful engine of capital formation, because it reduces the risk of government mismanagement of the economy to capital formation.

It might seem odd that tax legislation could be designed by demand-side economists and yet have positive supply effects. But the Father of Demand Management, John Maynard Keynes, argued that if economic weakness is caused by insufficient aggregate demand of consumers, the weakness could be alleviated by increasing government spending on projects that would have "multiplier effects" as the money spent rippled through the local, regional or national economy. If the rich were saving too much and not spending fast enough, the government could tax their resources away and either give the money to the poor, or lower tax rates on those who would spend the money instead of saving it. Even Keynes believed a tax rate could not rise above 25% without causing more problems than the revenue it raised. In his estimation, at such a limiting level, the government could borrow the money from the rich and use it to "prime the pump" of the economy.

There are only a few levers the federal government has to "manage" the economy. It can raise or lower tax rates. It can raise or lower the amount of "money" in the banking system. And it can pass regulations to inhibit commerce or to direct it in channels favored by those with influence over such things. To "manage" the economy in a supply model means knowing when to raise tax rates, and which ones, and when to lower them, and which ones. When it comes to knowing when to lower the level of liquidity in the banking system, all classical economists agreed that the price of gold was the best signal to follow. It still is, but our government now pretends it does not exist.