Questions on Lesson 4: Comparative Economics Jude Wanniski July 25, 1997

Supply-Side Economics Summer School Lesson #6

Memo To: Website students
From: Jude Wanniski
Re: Questions on Lesson #4

From Steven Piraino by email--

Professor Wanniski: After reading your fourth summer school article several times, there were several questions which occurred to me.  I would be appreciative if you could help clear them up.

Q1: What should be taxed and what shouldn't be?  A neutral tax code, one which minimizes economic distortions, would tax all wealth once, at a single rate, in the process of the wealth being acquired and consumed. Therefore, interest, dividends and capital gains should not be taxed if "earned income" is taxed.  However, wouldn't investment in human capital fall under the same category?  That is, shouldn't the wealth resulting from after tax income being channeled into productivity enhancing education and training be treated as a "human-capital gain," and go untaxed?  Of course the impossibility of calculating the "human-capital gain" would be a problem, but making education and training tax deductible would accomplish the same thing. Is there any real distinction between investment and consumption?  If investment in oneself is considered consumption, why?  How should it be taxed?

A: There are a great many questions here, any one of which would require a lesson in itself.

The most elementary answer is that in a constitutional democracy, anything people wish to tax should be taxed, as long as it is constitutional. There is no such thing as “neutrality” in a tax code. It is impossible to get more than two people to agree on what neutrality means, so put it aside. Your “therefore” assumption leads down a blind alley. If the nation wishes to tax interest, dividends and capital gains, it should be allowed to do so, as long as it understands the consequences. In the supply-side model, a tax on interest and dividends will not have the negative economic effects that a tax on capital gains will have. As we have discussed in previous lessons, any tax on a reward to successful risk-taking will subtract from economic growth. A society that does not wish to grow can successfully stop growth by punishing risk-taking.

The second part of this first question is about taxing the fruits of education. You have gotten tangled up in thinking about “human capital gain” and asking why we tax it. We don’t. All after-tax income that is spent on education that produces a gain in human capital is untaxed. In other words, after I pay taxes on ordinary income, I can invest that money in a financial asset, which can gain in value or lose value. If it pays interest or dividends, I pay tax on those. Or, I can invest that money in a human asset, my own education or the education of my children. I don’t get taxed on their human capital gain. They, however, pay tax on their ordinary income, which flows out of their human capital. The dividends and interest they may pay me in my old age are not taxed. And the process repeats itself.

Q2:  Isn't it a good thing to save one's income, so it can be used to purchase capital goods rather than consumer goods?  In the short run, the supply of consumer goods will decline, but the supply will be replenished and expanded once business begins using its capital goods to produce more consumer goods.  These goods will have to be sold at lower prices, due to the reduction in consumption, but because all that is produced must be consumed, they will be consumed nonetheless.  The price decline can be counteracted by increasing the money supply as the supply of wealth itself increases.  Do you deny this?  I believe you called this the demand-side argument for a capgains cut, didn't you?  Could you explain what is wrong with this logic?

A: We do not want people to spend less and save more. Those are demand-side objectives. We want them to be more productive, so they can increase both their savings and their consumption. People will be less productive, i.e., produce less, if they are told their surplus production will be heavily taxed if saved as a bond or invested as a stock. When people “save” they are not putting their money at risk in order to “buy capital goods.” John Smith bakes bread for a living. He produces twice as much as he can consume or trade for needed goods and service. The rest he exchanges for debt instruments, bonds or savings account, and the bread is consumed by people who are either too young to bake bread or have retired. When Smith gets sick or retires, he can redeem his savings for bread baked by a young Bill Brown, who is just entering his productive years. You cannot really explain this in a demand model, which is operating at full capacity. That is, the demand model assumes Smith has to consume less in order to save more. In the current world economy, there are no examples of economies producing at capacity. Everywhere, there are faulty tax and monetary systems that inhibit the expansion of production and trade, between Smith and Brown.

Q3:  You stated that cutting the capital gains tax encourages wealth creation by rewarding it with equity rather than debt.  Is this saying that people somehow value stocks more than bonds and will work harder for them? Doesn't that contradict Von Mises' assertion that the only real value is the market value, and therefore a dollar of stocks is, on average, as attractive to earn as a dollar of bonds or a dollar of candy, for that matter.  One person may prefer one to the other, but the market attaches the same value to them for a reason, no?

A: I said that growth is the result of risk-taking. The baker will save surplus bread if he can be assured he will get back loaves when he needs them in his old age. Once he has enough loaves stored away in debt, he may be willing to take risks, with even more loaves produced, now in exchange for equity. People will not work harder for equity than for debt. If anything, once they are secure in their holdings of bonds, they will not exert themselves as much to acquire stocks, especially if the stocks that perform well are taxed at confiscatory rates. Von Mises is saying something else. The market that prices A, B & C at $1 each and X, Y and Z at $1 each, may be setting different values according to different weights and measures: $1 for a pound of onions, $1 for an ounce of silver. In the same way, a $100 bond has expectations of a return on investment equivalent to the coupon interest rate. A $100 stock has expectations of returns depending upon the underlying asset. In other words, when you go to the racetrack, you can bet $2 on any horse. This does not mean they are all equally attractive. Over time, a $2 bet will yield the same returns over any schedule of odds, with a net loss to the players in aggregate. In the same way, over time all investment in equity will produce more losers than winners, but the gains of the winners will be sufficient to sustain the play of the market. In an interview in Wired magazine last year, which was the proximate cause of this Supply-Side University being founded, Peter Drucker essentially made this argument -- specifically asserting that in the history of banking, more money has been lost by banks than they have gained in profits for their owners. Think of it this way: More effort has been invested by humans in writing novels and movie scripts than has ever been recovered as profits to writers of novel and movie scripts. The capital gain, though, is available for humanity for as long as there is a market for a “Gone With the Wind,” or a “Wizard of Oz.” Humanity’s capital stock grows incrementally, on the backs of failure. One reason it all seems to work is that there is so much excitement in the process of almost winning and trying and trying again.