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Taxes on Investment

August 6, 2010

Conservatives are perpetually seeking to reduce taxes on the wealthy and their defense is always the same: high taxes on investment and capital reduce the incentive to invest.  Why would an individual invest if profits were eaten up by high taxes?  This argument has widespread traction and the result is the regressive fact that the tax rate on capital gains is far less than that on labor.  The argument, though, is demonstrably wrong as a simple math example will prove.

Let’s assume an investor plans on risking $100,000 with the hope of making a 10% return on the amount at risk.  If there is no tax on the profit, then the calculation would go like this:

Amount at risk: $100,000

Potential Gain:   $ 10,000

Potential Yield on amount at risk: 10%

Let’s now assume a tax rate of 60%.  The amount at risk is no longer $100,000 since the investor could deduct from taxes any loss.  If the investment is entirely lost, the investor would lose $100,000 but would claim the loss against taxes, netting a $40,000 loss after taxes.  The calculation would go like this:

Amount at risk: $40,000

Potential Gain:   $ 4,000 ($10,000 less 60% tax)

Potential Yield on amount at risk: 10%

I first saw this type of analysis in an article by Abba Lerner.  It effectively demolishes the conservative orthodoxy that taxes reduce the incentive to invest.  Based on this straightforward analysis, they should have no effect since the return on the amount at risk is constant.  (I know the tax laws on deductibility are not straight forward but in a well diversified portfolio, the above analysis does hold.)

From → Dynamics, Suppression

18 Comments
  1. Calgacus permalink

    Saw a similar observation in a Berkshire Hathaway annual report, saying the govt is the partner of the business, with the partnership interest the taxation percentage.

  2. Howard permalink

    This example assumes that our investor has gains greater than 100,000 to offset with his loss, a rather hefty assumption. If he doesn’t, he is risking > 40,000, changing your formula.

    It also assumes that s/he will cash the investment out at a 60% tax rate (necessary to realize a capital gain/loss), rather than leave the money where it is until a tax-advantageous transfer can be effected. Net result is that capital, rather than churning continuously and (sometimes) attracting towards more effective (read job-creating) ventures, lies stagnant in the same investment much longer.

    And the investors will always be able to find a more tax-advantageous way to do what they want to do. Just ask John Kerry.

  3. The assumption that the investor has gains to offset the loss doesn’t seem too hefty to me given that the very large investors – the ones that count on a macro scale – invest only a small percentage in any one venture.

  4. Howard permalink

    That was basically a throwaway point, meant to illustrate that your model is pretty static in it’s assumptions. My main point is that disregarding rational (tax-avoiding, in this instance) behavior is how Congress and the rest of the government continuously finds themselves on the wrong side of the law of unintended consequences.

  5. Of course it’s simplistic and static. It’s also not a model. It’s just an argument against the widely held belief that we need low taxes on capital in order to spur investment. Your point about tax avoiding behavior is well taken but we must remember that the tax laws are often written with the specific purpose of allowing evasion for certain groups. It’s an argument for closing loopholes, not for low taxes on capital.

  6. Calgacus permalink

    And the unintended consequence is not necessarily bad, as it is often a feature, not a bug of tax policy, to tax longterm gains lower. I think we could have survived the last decade as well, or better, with a bit less continuous financial churning.

  7. Howard permalink

    I’m all for closing loopholes, but as long as we have the permanent political class that we do, it will never happen. They close one and open 5 more according to the flavor of the day and who’s in power.

    Tax consumption and be done with it.

  8. Howard permalink

    Exempt the first 20-30k and/or certain necessities. The point is giving everyone, not just the wealthy, control over their tax liability.

  9. It will still shift the tax liability downward which is exactly against where we need to go. I agree we should exempt the bottom tranches from taxes (say 20-30k or more).

    Fairness is only one of the reasons I believe we need to drastically shift the tax burden on to super wealth. The most important, I think, is to reduce the political power of what can only be called an aristocracy. A near 100% tax on inheritances would be a great place to start.

  10. Howard permalink

    You may find it surprising that I agree with you to an extent about the problem of inherited fortunes creating an aristocracy. Unfortunately, the solution will almost always miss the mark. The super wealthy will co-opt those hoping to join their ranks (i.e. the career politicians) and the resulting legislation will contain holes big enough to drive a fleet of Brinks trucks through. How much revenue, after all, was actually derived from the top 70% tax rate prior to 1982? Somehow, we need to simplify the tax code to stop the lobbyists and tax lawyers from gaming it.

    However, I disagree that the lower brackets should pay less taxes. We already exempt nearly 50% of the populace from federal income taxes. Everyone should have skin in the game. I understand the argument about payroll taxes, however, that’s an entirely different matter. SS and Medicare were already a population-based shell game implemented disingenuously as a “savings account”. Even there, the lower brackets receive benefits all out of proportion to their contributions.

    • “Somehow, we need to simplify the tax code to stop the lobbyists and tax lawyers from gaming it.”

      Sounds to me that you’re advocating giving up – that we must 1) recognize and 2) accept the fact our political system is incapable of going against the interests of wealth. I agree with 1) but strongly disagree with 2). I don’t think we should accept it – we should fight to change the political system.

      Agree we should simplify the tax code – but that can’t mean taxing wealth less and the average working stiff more.

      “lower brackets receive benefits all out of proportion to their contributions.”

      Of course you’re making the assumption that the labor ‘market’ fairly allocates income. That those on the bottom – the janitors, construction workers, many teachers, etc, etc. should logically and fairly receive but a tiny fraction of the income of a lawyer, CEO, real estate salesman, Park Avenue inheritance child, etc. There’s nothing logical or natural about this distribution. It’s merely an institutional feature of our socio-economic system. I agree “lower brackets receive benefits all out of proportion to their contributions.” Their benefits are way below their contribution.

  11. Howard permalink

    In the benefits/contributions calculus, I was speaking only in terms of Social Security and Medicare. As to how to fairly value labor, I confess to not feeling competent to judge the value of most jobs’ contribution to their enterprise. I think that in general, people are worth what someone is willing to pay them. This excludes the obscene compensation packages that so many of today’s executives incestuously approve for each other through their interlocking board memberships. I’m uncomfortable with any scheme that purports to declare a relative value between jobs. Someone has to then make that determination, which creates a powerful institution, into which inevitably jumps our friendly political class.

    Which segues neatly into my unease with progressive vs regressive taxation arguments. Someone always gets to make the decision as to how progressive is progressive enough. This power inevitably leads to corruption. Some type of flat tax with the bottom portion of income protected seems to me the “fairest” way to go about funding government. Next question, of which sight has been completely lost, is that of what and how much the federal government should do.

    I don’t advocate giving up, far from it. Unfortunately, I fear the only way to reform this system is to conduct a pogrom that banishes every Ivy League “bigbrain” from finance and politics.

  12. Don’t disagree with the last comment.

    As far as valuing labor: the key moral issue is whether human beings should be considered a commodity. Obviously I think not.

    I’m against state power as well. I think some form of social contract can be done without a huge bureaucracy. Everyone has a guaranteed basic income and nobody makes more than x. It could be a simple line item on the tax form.

    Also, it must be kept in mind that neither taxes nor borrowings are needed in order to maintain living standards for all. I wrote about this most important point in my post Deficits Don’t Matter!

  13. Howard permalink

    Always amuses me how much people like you and I have in common. Our goals are pretty much the same, although we probably come at solutions from different angles. Our “two” parties like to keep trying to work idiotic wedge issues that anyone with a grain of sense would see first of all don’t really matter in the grand scheme of things, and second of all are not really appropriate for government to regulate. I think as Americans we have much more in common than we have in difference.

    Keep up the good fight, Jim.

  14. I do believe that if we got past the wedge issues we’d see that the vast majority of Americans have much in common and agree on basic principles. The key is how to cross the polarization divide. It’s made my day to see that we were able to bridge some divides.

    Enjoyed the conversation, I’ll keep up the fight, and hope to hear from you again.

    Take care Howard,

    Jim

  15. Howard permalink

    Right back atcha, Jim.

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