Archive

Tag Archives: Capital Gains

By George P. Brockway, originally published September 21, 1992

1992-9-21 The Malignity of Capital Gains Title

THE RECURRING wrangle over the fairness or unfairness of capital gains taxation, while certainly not irrelevant, has distracted attention from the malign effects on the economy of the search for capital gains.

We hear on the one side that they are largely the concern of the rich, and of their pursuit by rapacious business executives. On the other side we are told tales of young men enabled to realize a great invention with the help of a timely investment by some capitalist with vision. We learn, too, of family farms and family businesses, of personal art collections, and of great tracts of unspoiled wilderness that would not be put to their best social uses if equitably taxed.

We hear all of these things, and most of them are true, or could be true. But we hear little or nothing about the influence of the search for capital gains on the stock market and, through the stock market, on the efforts of the Federal Reserve Board to stimulate the economy.

It is a source of much puzzlement that the Reserve’s well publicized three-year long assault on short-term interest rates has done, if anything, the opposite of what it was intended to do. Since the summer of 1989 the Reserve has cut short term interest rates more than 20 times. The expectation, of course, has been that lower rates would encourage producers to borrow and invest in plant expansion and modernization. The resulting increased employment, coupled with lower rates on consumers’ loans, would encourage consumers to buy, thus validating the producers’ expansions and setting the economy on a sustainable upward curve.

The plan made sense from almost every economic point of view, yet its failure is manifest. Producers are shutting down plants instead of opening new ones; unemployment has risen painfully; corporate profits and personal savings are both down; retail sales continue to be disappointing.

For most of the economy 1991 was a bad year, and 1992 is worse. But one sector flourished, and continues to flourish. Nearly all brokerage houses are prosperous, some of them more so than ever before. The stock exchanges, despite waffling between their January and July peaks, have been buying and selling at a record rate.

It has been a long time since Wall Street was primarily concerned about the business prospects of the firms whose shares the exchanges trade in the hundreds of millions every business day. Two statistics dominate the thinking of speculators. The first is unemployment, which is a worry because there is supposed to be a trade-off between unemployment and inflation. But in only three of the 46 years since the end of World War II has unemployment been higher than it is today; so regardless of the validity of the supposition, there is little fear of an imminent resurgence of inflation.

The other number that concerns Wall Street is the interest rate, because the capitalized value of any income-earning asset goes up as the interest rate goes down. The reaction of the secondary market for short- term bonds and notes is almost automatic. The long bond market, being congenitally fearful of inflation, follows at a more circumspect pace. As the prices of bonds rise, common stocks become more attractive investments, both for income and for capital gains.

Therefore, as the Federal Reserve Board has lowered the interest rate, the stock market has climbed. Investors especially speculators eager for capital gains-have rushed to take advantage of the quick profits. Money has poured into the stock market.

Now, that money obviously had to come from somewhere, and its ultimate source had to be the producing economy, where things are made and sold and services are performed and paid for. It may be old money from CDs and money market funds and bonds, or it may be new money borrowed at the new interest rates. In either case, it is money that the rising stock market denies to the producing economy. The lower interest rates, instead of stimulating the producing economy, have caused money to be drained away from it. Hence the deplored credit crunch.

Unfortunately, there is nothing the Federal Reserve Board can do about this. A continuation of the policy of lowering the interest rate will lead to a continuation of its consequences. A determination to stand pat will leave us in our present doldrums. A reversal of policy, raising the interest rate, will not only deepen the recession but very likely cause the market to crash. Moreover, when the market crashes the money that is lost simply disappears. It is not returned to the producing economy, nor does it reappear as cash in someone’s pocket.

Gross private domestic investment, as a percentage of GNP, was practically unchanged in 1986, 1987, and 1988 (the year before the crash, the year of the crash and the year after the crash). The percentages were 13.5, 13.1, and 13.8, respectively. As for cash, M1, which includes it, fell in 1987 as the market fell. The lost money was gone forever.

Was the Reserve wrong, then, to reduce the interest rate? Certainly not. Usurious rates are largely responsible for the recession, and still lower rates will be necessary to end it. It is true that the discount rate is now lower than it has been for 30 years. It is also true that it is three times what it was in 1947 and six times what it was on special advances in 1946.

Although the Reserve Board’s recent intentions bay be good, they have been, and will continue to be, overwhelmed by the altogether understandable rapacity of seekers after capital gains. It’s easy to make money on a rising market, but you have to risk a dollar to make a dollar. The dollars that you risk are dollars you might have risked in buying a new machine for your factory or in replenishing the inventory of your store. Your broker will try to tell you that by buying a share of stock you are producing goods just as much as if you were buying a machine for your factory. But of course the stock and the machine don’t both produce goods and it takes time to make money with the machine, while you can do that on the stock exchange very fast. So if you’re smart, you will play the market, and the Federal Reserve Board will be frustrated.

If the Federal Reserve cannot get us out of this mess we are in who can?  Unwittingly, President Bush has pointed the way – even though, characteristically, he was looking in the other direction. He has proposed a low capital gains tax, and a still lower tax on gains on some assets held more than five years. It won’t take you very long to see that his proposal would merely make more attractive the speculation that drains money from the producing economy.

Yet a sliding tax scale could take the profit out of speculating. If I had my druthers, I would have a capital gains tax that went something like this: Gains on some assets held more than five years would be taxed at 95 per cent, gains on assets held more than a year but less than two years would be taxed at 90 per cent, and so on, with the rate falling 5 points a year for 10 years.

Some changes in the tax law should be made regardless of the rates. Gains certainly should be taxed when assets change hands by gift or bequest as well as by sale. Capital gains of otherwise tax-exempt institutions should be taxed, because such institutions are responsible for much of the current market churning. On the other hand, it would be desirable to exempt principal family residences that fall below a certain value, along with small family farms and businesses.

Capital gains are an archaic form of profit. Despite their name, they are typical not of the capitalist system, but of mercantilism and more primitive economic systems. Likewise, the speculation that gives rise to them is an archaic form of economic enterprise. In the Renaissance the merchants of Venice organized each commercial voyage as a separate affair. Their personal experience taught them the sorts of goods most likely to be wanted on the Golden Horn. They stocked their outward bound galleys accordingly, and they brought home the sorts of things they could sell quickly and profitably at the quayside. The system was a series of speculative ventures, making the most of ad hoc opportunities to buy cheap and sell dear. When the selling was ended, the enterprise was ended, too. Capital gains are realized only when an investment is withdrawn and ceases.

In contrast, a modern corporation is a continuing enterprise. The basic concepts of classical and neoclassical economics are irrelevant to it. It could not continue if its market were “cleared. Since its market is not cleared, the “law” of diminishing returns is obviously violated. If the law of diminishing returns does not apply, there is no “margin,” and marginal pricing is impossible. If marginal pricing is impossible, “equilibrium” is neither necessary, likely, nor desirable. (And this is a good thing, for as all theorists from Leon Walras to Gerard Debreu acknowledge, economies of scale – the ideal mode of modern business enterprise – are impossible under equilibrium.)

Four years ago it was argued (fallaciously) by candidate George Bush that reducing the capital gains tax would increase tax collections (see “George Bush’s New Trojan Horse,” NL, September 19, 1988). His lips seem to be buttoned shut on that one today. Now we are told that reducing the tax would stimulate business, a notion dear to the far Right, which nevertheless mysteriously mistrusts him. But surely the Federal Reserve Board has had enough experience in the past three years to prove that to encourage capital gains is to encourage speculation, and that to encourage speculation is to induce a credit crunch that throttles productive enterprise.

A low capital gains tax is unfair because it is for the principal benefit of the rich. It is also economically counterproductive.

The New Leader

By George P. Brockway, originally published February 5, 1990

1990-2-5 Social Gains and Capital Security Title

TRYING TO UPSTAGE New York’s Democratic Senator Daniel Patrick Moynihan, who wants to stop using the Social Security Trust Fund to reduce the budget deficit, the Bush Administration has concocted something it calls the “Social Security Integrity and Debt Reduction Fund.” This is supposed to do part of what the Senator is urging, but in 1993 instead of now. The Senator, of course, had a pithy comment: “It is well known that the Federal budget is always in balance three years from now. Never, however, now.” It is equally well known that the Administration’s sudden action is motivated by fear that Moynihan’s proposal of a tax cut for everyone will show up President George Bush’s proposed cut in capital gains taxes as the rich man’s scam it is.

1990-2-5 Social Gains and Capital Security Daniel Patrick Moynihan

Among the many things wrong with the Social Security tax, the two principal ones are, first, that it is regressive; second, that it is a tax on employment and both adversely affect the distribution of income. The regressiveness is generally recognized, except by those who have come to believe that all taxes must be regressive. Budget Director Richard G. Darman, for instance, claims the Moynihan tax cut would have to be replaced by some new tax that would fall on the same people and therefore be just as regressive. But that is nonsense.

Not very long ago the Federal income tax had a progressive schedule that exempted the lowest incomes and then ran from 11 per cent to 70 per cent. The top brackets were knocked off under Presidents

Richard M. Nixon and Jimmy Carter, with a 50 per cent maxitax substituted. For a brief period, a 35 percent bracket was added to the capital gains tax, making it somewhat progressive. This was soon dropped, unfortunately, and opportunities for tax shelters were so expanded that when they were largely eliminated by the current tax law it could be claimed that lowering the top bracket to 28 per cent or 33 per cent was revenue neutral. (“Revenue neutral” was Ronald Reagan’s educated way of saying Read my lips.”)

Some argue that while the Social Security tax is regressive as it is collected, it is progressive as it is paid out. The examples usually given are not encouraging. They show people who evidently lived in constant poverty, paid a high percentage of their minuscule incomes in taxes, and retired to receive benefits exceeding the taxes they had paid. But they were below the poverty level all their lives nothing to cheer about. Anyway, there is no reason on earth why Social Security should not be progressive when it collects as well as when it pays out.

Furthermore, from the point of view of the Social Security system, there is no reason to replace the Moynihan tax cut. When Bush says, “The last thing we need to do is mess around with Social Securiity,” he implies that the Moynihan tax cut would reduce benefits either now or in the future. I’m sorry to say that Senator Moynihan allows us to make the same inference when he quotes a newspaper’s opinion that using the Social Security surplus to balance the budget is “thievery.” I’ll grant that it is skulduggery, that it is intellectually dishonest and economically counterproductive and unjust. People are conned into paying an unfair tax and liking it. Still, it is not thievery. No one gets away with anything, except politically. Neither present nor future benefits are at risk-at any rate, no more at risk than they will be no matter what happens.

Budget Director Darman suggests that the Moynihan tax cut would make it necessary to raise taxes a couple of decades down the road to pay the baby boomers’ benefits as they reach the golden years. Yet taxes will have to be raised for that purpose then whether they are cut now or not. What is the Social Security surplus anyhow? It is not a bank vault stuffed with crisp Federal Reserve notes. It is simply some entries in a ledger showing that the Social Security Trust Fund owns some Treasury bonds.

Once the boomers’ benefits have to be paid, the Treasury will be asked to redeem the bonds for cash. The Treasury doesn’t have a bank vault full of Federal Reserve notes, either. To get the money, it will have to ask the President and Congress to use some of that year’s taxes to make good on the bonds. This will happen regardless of the size of the surplus, just as the benefits I am now receiving come out of current taxes, regardless of what and when I paid in.

People talk about Social Security as a sacred trust, and it’s pretty close to that. There is no doubt that millions of citizens depend on the benefits and are scared whenever they hear talk of changing them. Actually, changes are made every year as the cost-of-living allowance is adjusted, and there have been changes several times for other reasons. The present growing surplus is a consequence of comprehensive revisions made in 1983. Because I own some municipal bonds, half of my benefits are now subject to income tax. I didn’t agree to that; the President and Congress just hauled off and did it, and it costs me over $2,000 a year. I don’t object in principle, because I think all Social Security benefits should be taxable, and I think all municipal bond interest should be taxable. (But I do feel it is a mite unreasonable not to tax everyone who has one or the other. Why me?)

Besides being regressive, the Social Security tax is a tax on employment. It taxes workers for working, and it taxes employers for hiring them. In addition, because production is achieved solely as a result of work, the Social Security tax is a tax on production.

Yet the Chamber of Commerce and the National Association of Manufacturers and the Business Roundtable have not rallied around Senator Moynihan. That’s rather remarkable. Half of the Social Security taxes are paid by businesses, from the smallest to the largest. And the half paid by employees is a drag on business, too, because it contributes to costs. Moreover, the paperwork involved is bothersome and expensive (or so they used to complain).

It would appear that business associations are more interested in the capital gains tax, which is paid by their members as individuals, than in the Social Security tax, which is paid by the businesses they supposedly are acting for. Well, we shouldn’t be surprised. Very little of what is reported as business news has anything to do with producing goods or services. Takeovers, buyouts and the like make big headlines – and big changes (usually unpleasant) in the lives of workers and the cities they live in. If there is evidence of these shenanigans having a positive effect on the production of goods and services, it is a well-kept secret. Nevertheless, that is the sort of activity the President is eager to encourage by reducing the capital gains tax.

IRONICALLY, the same sort of activity would be encouraged should Senator Moynihan succeed in the second half of his ambition: to use the Social Security surplus to buy up all the public debt. The private funds released would, he reasons, be saved. Since it is a widely propagandized faith that our troubles are caused by our failure to save, the Senator imagines that prosperity would be around the corner.

I have previously discussed John Maynard Keynes‘ theorem that saving equals investment (see “Much Ado about Saving,” NL July 13-27, 1987). What I overlooked in my discussion (and what Keynes overlooked in his) is that “investment” covers many noble works and a multitude of sins. If you have saved some money and want to invest it, you can buy a factory (fixed capital), goods to sell (working capital), some common stock (claims on future profits), bonds (which will pay fees for the use of your money). You can also put your money where your mouth is in Las Vegas or Atlantic City or any of several state-run lotteries. You can buy land or a collection of beer cans or rare stamps or a painting by some pseudo-Monet. That is not all, but it gives the idea.

When you come right down to it, only the first two items (fixed capital and working capital) are investments certainly intended to result in production of additional goods and services. A company issuing stock gets its money from the first sale; no subsequent sales have any effect on production. In some instances, even the proceeds from the first sale may be intended merely to finance the purchase of another company, whose takeover may not in any way expand total production. As for the other kinds of investments, it is plain that they are speculations and have nothing whatever to do with production.

Consequently, although saving may equal investment, as Keynes argued and as most economists today agree, and although production requires investment, it by no means follows that all investments are productive of goods and services. In the present state of our economy, there are not enough sound productive investments for the money already available. The lack of attractive investment opportunities is frequently cited as the reason banks became involved in the Campeau fiasco. When productive investments are scarce, money runs to speculation, as it has been doing in a turbulent stream for the past decade.

In spite of the irrelevance of any hoped-for encouragement of saving, Senator Moynihan’s proposal offers a big step toward solving the fundamental problem of the maldistribution of income. If the Senator’s Democratic colleagues were as wise in statesmanship as he (and as astute politically), they would rally to his standard instead of sulking on the sidelines pretending to be “responsible.”

After all, a very strong case can be made for the proposition that the Reaganomic shift of the tax burden from the rich to the poor is largely to blame for the stagnation of the economy and (if you want to fuss about it) the escalation of the deficit. This case is, indeed, far stronger than that for the Bush myth that cutting the capital gains tax would stimulate productive investment and increase tax collections (see “George Bush’s New Trojan Horse,” NL, September 19, 1988). If the Democrats were not determined to self-destruct still another time, they might combine the Moynihan and Bush proposals in a single bill, and let the President worry about being “responsible” for a change.

 The New Leader

By George P. Brockway, originally published September 9, 1988

1988-9-9 George Bush's New Trojan Horse title

GEORGE [H.W.] BUSH has the distinction of introducing the only tax issue into this fall’s Presidential campaign.

For anyone whose interest in government or economics goes beyond personalities, taxes are endlessly fascinating. The power to tax is the power to destroy – and also the power to create. It is a sign of the shallowness of our society that the eyes of so many people of all ages and both sexes glaze over when the subject comes up. It is a sign of the shallowness of Bush’s understanding – or the deviousness of his intentions – that he wants to upset one of the best features of the 1986 tax law, which treats capital gains as ordinary income. He wants to tax them at 15 per cent – the lowest rate since the grand Depression days of Herbert Hoover.

A tax – the StampTax – crystallized the colonists’ dissatisfaction with England and led to the American Revolution. Another tax – the so-called Tariff of Abominations – led to the nullification crisis of 1832, and ultimately to the American Civil War. In both cases much more than taxes was involved; yet taxes were central issues in the great wars that made and preserved our nation.

Taxation can serve one or both of two purposes: It can raise revenue to pay the costs of government, and it can encourage or discourage various activities. The Revolution was fought (in part) because the Stamp Tax did the former, the Civil War (in part) because the tariff did the latter. In 1767, John Dickinson wrote in the second of his Letters from a Farmer in Pennsylvania that before the Stamp Tax, taxes “were always imposed with design to restrain the commerce of one part that was injurious to another, and thus promote the general welfare. The raising of a revenue thereby was never intended.” In contast, in 1832, South Carolina passed its Ordinance of Secession that denounced the tariff because of “bounties to classes and individuals … at the expense of other classes and individuals,” and espoused the theory of taxation for revenue only.

A more general theory appears in Alexander Hamilton‘s classic Report on Manufactures (1791): “[T]he power to raise money is plenary[1] and indefinite, and the objects to which it may be appropriated are no less comprehensive than the payment of the public debt, and the providing for the common defense and general welfare.”

All three of these theories are involved in Bush’s tender concern for capital gains. Of the three, he has pushed most strongly the one dealing with revenue. In this he is supported by Treasury Department Research Paper No. 8801, “The Direct Revenue Effects of Capital Gains Taxation, which argues that a lower rate brings in higher revenues. There are opposing views, specifically those of the Joint Committee on Taxation and the Congressional Budget Office. And much private ink has been spilt on both sides.

On one level, the question is an extreme case of that raised by the Laffer Curve, and of Peter Peterson‘s claim that the rich pay more taxes when the rate is lower (see “In for a Penny, In for a Pound,” NL, June 13). The case is extreme because Bush’s proposal would cut the capital gains rate roughly in half, requiring capital gains “realizations” to double just to keep revenues running in the same place.

The latest figures the Treasury research paper gives us to work with are those of 1985, when the marginal rate was 20 per cent, capital gains realizations were about $169 billion, and the revenue raised was about $24 billion. Since 20 per cent of$169 billion would be almost $34 billion instead of $24 billion, it is obvious that the capital gains tax, even though admittedly mostly falling on the superrich, was paid by many whose Adjusted Gross Income was less than the $175,251 then needed to boost a married couple into the top bracket. Obviously, too, once the new tax law settles down and a married couple with an Adjusted Gross Income of $29,751 finds themselves in the top bracket (28 per cent), practically everyone with any capital gains will be paying the top rate.

Neither you nor I nor even George Bush knows what the future will bring. It is probable that realizations were up in 1986 and down in 1987. A large part of what was realized in 1986 (including everything I cashed in) was in anticipation of 1987’s higher rates, while a large part of what was realized in 1987 was losses in the stock market’s Oktoberfest (me, too). It is likely that realizations this year will be greater. No matter: For Bush’s scheme to work, they must more than double what they otherwise would be. The question I ask is: Do we want that to happen?

To answer that question we have to look at where capital gains come from. They come about in two ways: (1) a company retains and reinvests its income instead of paying it out in dividends, thus increasing its net worth and, presumably, the market value of its shares; or (2) goods (especially real estate and works of art) increase in value because of market shifts or inflation, thus tending to lock holders into property they might otherwise have wanted to sell. It is received doctrine that the first method should be encouraged, and that adverse personal consequences of the second should be mitigated; hence the special treatment of capital gains. In Britain, and generally on the Continent, they are not taxed at all, making George Bush more moderate than he may find congenial.

A company that reinvests its income grows. The more companies grow, the more the economy grows: more goods, more jobs, more profits. Assuming that for a given company expansion makes sense, the necessary capital can be raised by borrowing, by selling new shares of stock, or by retaining earnings. Interest payments on borrowings are a deductible business expense, while dividends on stock are not. On the other hand, interest payments are a fixed expense, while dividends, again, are not. Balancing the foregoing considerations, a fairly prudent and sanguine management will opt for borrowing, but a company that can satisfy its stockholders with capital gains will enjoy the best of both worlds by relying on its retained earnings.

In addition, it is said that the possibility of capital gains attracts both entrepreneurs and investors to new businesses, which are the economy’s hope for the future.

Since retained earnings are rarely enough to do the job for a rapidly growing concern, its real choice is between issuing new stock and shouldering new loans. There would be no problem at all if interest payments were not a deductible business expense. The 1986 tax law has partially eliminated it as a personal deduction. I’ve made the case for eliminating it for business, too (see, “A Tax Increase by Any Other Name,” NL, November 24, 1984[2]) and shall only outline it here. In brief, the deduction, although it seems to subsidize the borrower, in fact subsidizes the lender. Without the subsidy, interest rates would have to fall, because few could afford the raw rate.

Moreover, the subsidy is meaningful only to an already profitable company, given that a new enterprise typically operates at a loss for some time and can’t afford to borrow at all. It has no net income from which to deduct the interest expense, and therefore has to pay the usurious raw rate on whatever it borrows. In sum, if you want to encourage new enterprise, you will eliminate the deduction for interest expense and will consider the treatment of capital gains more important for personal than for business finance.

DOES IT, then, make sense to encourage individuals to seek capital gains twice as eagerly as they seek earned income? What is actually encouraged, of course, is wheeling and dealing. It is not impossible that some good enterprises are thus sponsored that would not have been undertaken otherwise; but it is quite certain that wheeling and dealing raises the cost of capital for all enterprises, new and old, good, bad and indifferent. It is also certain that, whatever the ills we have recently been suffering, they were not caused by a lack of wheeling and dealing.

Finally, it is urged that capital gains are, for most individuals, an unexpected and even unwanted consequence of inflation. The house you bought for $100,000 five years ago can be sold for $200,000 today, which is dandy. But you have to have some place to live, and an equivalent new place will cost an equivalent number of dollars, or $200,000. An ordinary tax on your capital gain (28 per cent under the new law) would leave you $28,000 poorer than you’d have been if you hadn’t moved. Bush would leave you $15,000 poorer, and that is better, but not great. (There are, to be sure, special ways to handle this special problem, and some of them are embodied in the present law.)

Any attempt to offset the general effects of inflation, however, winds up by encouraging it. Conservatives of Bush’s school colors are quick to see that wage increases tied to the cost of living are inflationary. The same is true of capital increases. As a matter of fact, capital increases are even more inflationary for reasons we’ve previously discussed (see “Vale, Volcker,” NL, June 1-15, 1987). The very possibility of capital gains stimulates the frenetic search for more of them; it’s easier than working.

Indeed, it is precisely this frenzy that Bush wants to stimulate. As the Treasury has told us, capital gains realizations in 1985 were $169 billion. On the same realizations, the present rate of 28 per cent would yield $47 billion, and Bush’s rate of 15 per cent would yield $25 billion. For Bush to bring in more revenues than the present rate, he would have to push realizations beyond $340 billion, or more than twice the highest they’ve ever been before.

Since 1966, capital gains realizations have steadily increased, from $31 billion ($67 billion in 1985 dollars) to the present. It happens that, as Professor Hyman P. Minsky points out in his recent book Stabilizing an Unstable Economy, since 1966 “the American economy has intermittently exhibited pervasive instability.” While not necessarily conclusive, the association of these facts is at least suggestive, especially when you remember that instability is another name for the volatility that comes with wheeling and dealing.

Bush deserves a good mark for daring to talk about taxes. But he has offered us another Trojan Horse to make the rich richer. Let’s suppose he succeeds and manages to boost capital gains realizations to $340 billion. Then the after-tax income from capital gains would leap to $289 billion-more than double that of any previous year. As we said in discussing Peter Peterson’s ideas of taxation, this is the way multimillionaires are made.

The New Leader


[1]complete in every respect:  absolute, unqualified

[2] Editor’s note:  The name of this article in print is “The Bottom Line on Tax Reform.” From time-to-time the New Leader replaced the author’s title with another.  This is one case.

%d bloggers like this: