On reforming the capital gains tax and distorting the value of wealth

While glancing over a study guide on macroeconomic theory cowritten by Nobel Prize winner Joseph E. Stiglitz, I came across a particularly useful argument against certain subsidy policies.  Subsidizing the steel industry, for example, cost the US government in terms of tax dollars and tax revenue, but it also drove a far larger sum of capital, due to investment and demand, away from other industries inside the domestic economy instead of attracting new investment as was the intended goal. 

In terms of economic activity somewhat disconnected from the globalized economy, subsidies provide greater costs and fewer benefits to a domestic economy than should be assumed at first glance.  In terms of subsidizing a globalized segment of our economy, the policies of a single nation, China or the US with regard to oil and agriculture as bold examples, can seriously hurt the economies of other nations and the global economy as a whole with few benefits going to the offending country.  Inevitably, all countries must eventually pursue their own domestic interests over the interests of others while doing so can be damaging, or beneficial, to the International Community.  Consequently, policymakers need to do a better job of recognizing the costs of their subsidy policies while economic researchers also need to offer better insight to the public. 

Extrapolating from the original example, countries around the world subsidize a variety of segments of their economies via tax exemptions, tax credits, outright payments, discounted resources, and other mechanisms.  In many countries, taxpayers receive a discount for the taxes owed on the returns of their investments, thus wealth is valued higher than earned income and intellectual property.  In the US, what investment activities qualify for the capital gains discount has changed with the political climate.  At times, policy swifts support the broader interests of the American People; other times, they favor only a handful of individuals while the capital gains tax has long been generous at around 20 percent under the Clinton Administration and around 15 percent under the George W. Bush Administration. 

For most Americans, the discounted tax for capital gains serves as a long-term incentive to invest their monies as to ensure their financial future and the country’s economic stability.  For wealthier Americans, however, the discount is not an incentive to invest; it affords them a windfall for monies they would have already invested, though altering it may change how they invest.  As stock markets afford individuals a convenient vehicle for their investments, versus directly risking their savings in a business venture in a more localized economy, most people invest in our national/global economy through a 401K retirement plan, an IRA, a mutual fund, bonds, CDs, and other financial instruments.  In terms of the above analysis, this means monies are funneled into investments sanctioned by the government with the greatest benefits going to those segments expected to grow the fastest. 

The benefit to the economy is a readily available, broad base source of capital that can be used to expand economic activities in the Main Street economy.  This has helped make the financial sector one of the strongest.  Unfortunately, the financial sector does not demand a great deal of labor as compared to the greatly diminished manufacturing sector and the overall need.  Consequently, steering too much money into the financial sector may well have hurt the economy as a whole, because doing so diverts money away from the economic activities that financially benefit the majority of Americans. 

People need well paying jobs to sustain strong consumer spending, i.e. the lifeblood of the economy, and build their investment portfolios, i.e. access the benefits of economic growth and supply the economy with capital, while enjoying a comfortable lifestyle.  When the majority of people lose their ability to both afford a comfortable life and invest for their future, the economy is unsustainable.  From the 1970’s until about 2008, average income Americans were able to compensate for diminishing wages and lost financial opportunities by working longer hours, living on multiple incomes, decreasing family size, forgoing certain luxuries, relying on state support, and, in the case of the growing poor classes, forgoing necessities, thus ultimately hurting themselves in the future.

Furthermore, today’s economy is built on increasing returns to those can afford to be investors.  This translates into a situation where an excess of capital is driven toward investments with the highest payouts, thus creating bubbles.  Wall Street firms and affluent individuals have been increasingly able to use extremes in the markets to siphon capital out of the economy, especially with their use of exotic financial instruments and commodity futures.   Because emerging economies often see periods of faster grow than developed economies, capital is being increasingly routed to outside ventures via investor choices, especially among professional investors, an over reliance on imports, outsourcing, and crescendoing commodities prices. 

In tandem, production is cheaper in underdeveloped countries due to abundant, underdeveloped natural resources, cheaper human resources, and a lack of important regulations while only a relatively few in these underdeveloped countries significantly benefit from the exploitation of their national resources.  As such, excess capital does not primarily benefit the majority in developed countries paying the price for the capital gains subsidies in terms of expanding labor intensive industries.  In fact, it is likely fueling the growth in underdeveloped counties that is undercutting labor intensive industries in developed countries instead of fueling novel industries throughout the world.  Although the US, Japan, and Europe are stalwart economic safe havens, growing uncertainty in these economies and growing, yet fluctuating, confidence in emerging markets means capital is more often going to be diverted to developing nations in the future.  Manufacturing, for example, has started to return to the US, but price instability for commodities like oil is helping to drive this resurgence; should costs stabilize and foreign imports continue to become more reliable as is needed, this industry and similar ones will once again see decline.

Consequently, the capital gains tax needs to be recalibrated to better reflect the interests of national economies.  Beyond an immediate, honest effort to better understand and discuss the effects of tax policy, we need to hold a constructive public forum on the issue that actually leads to action.  This starts with economic researchers developing economic models that do not over value wealth capital by undercutting the value of intellectual and labor capital.  In the short-term, any action will likely facilitate already inevitable corrections in economic sectors where growth has been inflated and economic measures focus far too heavily on, yet over time it will stabilize our economy and promote sustainable growth where we need it the most.  (As for double taxation, tax purchases made with already taxed earned income is a double taxation situation.  Applying both a capital gains tax to funds subject to a corporate income tax is, at least, just as unfair, though governments often allow corporations some deduction or accounting trick to effectively reduce double taxation.  When the capital gains tax is solely applied to the returns on an investment, not the original principle, double taxation is not at play.) 

Action in the United States may well translate into capping the benefit of the capital gains income tax, so it can act solely as an incentive for middle income households.  Paying down the National Debt is one option while shifting the tax savings associated with the truncation of the capital gains tax discount is another.  Cutting overall tax rates would be nice, but governments might consider subsidizing another type of capital that would drive grow where it is most needed.  With free trade, policymakers and economists assumed Americans would develop an economy fueled by the service sector and intellectual property.  Clearly, this model does not provide for the interests of most Americans as most do not own significantly valuable intellectual property and service industry jobs are often low paying, but policy shifts can help better spur the good paying jobs people need.

Improved business models, technological advances, economic uncertainty, and a lack of demand have created an economy that does not need the skills and labor of millions. Innovations and the spread of new technology can, however, create good paying jobs by sparking novel industries.  Coupled with improved patent laws, offering a tax discount on par with current capital gains tax deductions for royalty payments on novel technologies and other innovations would make them far more valuable.  By making patents and other intellectual property more valuable, financial capital would be steered toward innovation, thus ultimately creating new industries and jobs. 

It also means innovative individuals would enjoy a far more privileged position in our economy as they would be a more significant source of wealth and their intellectual property would afford them greater leverage in the economy.  Additionally, instead of selling off old technology to foreign countries, which helps drive outsourcing, companies would have greater incentive to hold onto patents and production.  Most importantly, businesses would be pushed into investing in research and development instead of simply waiting to purchase innovations at a discount.  Moreover, financial capital is valued higher than intellectual and human capital, but changes in tax policy could fix this impropriety.