Saturday, February 18, 2006

More of the Same from the Democrats, Again

My congressman, Democrat Rahm Emanuel of Chicago has had a tax proposal on his web site for a few weeks. This week he and Sen. Ron Wyden (D) Oregon wrote this article (subscription site) on that subject for the Wall Street Journal. They mix some good ideas with one horrible idea that continually rears its ugly head when Democrats get together; they want to raise taxes on one of the most important building blocks for businesses, I'm talking about capital. We can not have growth in this country without capital, people would not have jobs without adequete capital. Why the Democrats want to tax a fundemental building block of job creation is beyond me.

The good ideas in the article are common sense suggestions to simplify the tax code and if I’m reading this article correctly they advocate cleaning up the picayune special interest deductions that are rife in the federal tax code. I did not notice any suggestions to systematically keep the tax code clean of those picayune deductions.

The two Democrats state that their proposal would eliminate “the unfair ways wages and investment income are currently treated”. This is an ongoing lament of Democrats; it has been used successfully over the years to support the Alternative Minimum Tax (AMT). Elimination of the AMT is one of their suggestions, so at least the Democrats are starting to see the light on that particular tax. The reality is that the AMT net has gotten so big that they are hearing about that tax from their constituents.

The glaringly bad idea is one which would make us less competitive than we should be in the arena of attracting capital to our businesses. They want to raise the capital gains tax. Nowhere in the article or on Mr. Emanuel’s web site is the issue of capital formation addressed. By capital formation I mean the ability of corporations, partnerships and individuals to raise the necessary capital to start or expand businesses. My hope is that there is nobody left in America who would say that humans do not react to tax rate changes. After all, this is a nation of people who will drive well out of their way to save a few cents per gallon of gasoline. Taxes involve much more than a few cents per gallon. It is important to remember that investors are human and that humans react to stimuli.

Starting a business is difficult and risky work; this is easily seen in the business failure statistics. The vast majority of businesses fail within five years, making an investment in a start-up business a risky venture indeed. Those of us who advocate lower capital gains taxes understand that a business start-up is a very risky venture and that if we as a society lower the cost of the successful ventures then successful business owners will be more willing to risk their capital again rather than socking it away. Whether they risk their capital in a new venture or expand their original venture does not matter, they are creating jobs and opportunities for people. The retort that most capital gains do not involve actual start-ups ignores the use of capital for expansion and the very real effect that secondary markets have in capital formation.

Secondary markets in this case are markets made in stocks that have already been issued to the public through Initial Public Offerings (IPO); it is the stock market that we see in the paper every day. Lively secondary markets mean increased liquidity, meaning in this case, that an investor can sell a holding easily and at a fair price. Lower capital gains taxes help spur investors to put their capital into the secondary market and thus add to that liquidity. That pool of liquid capital is an added incentive to those who put their capital to work in the riskier early funding stages of companies. The lively public secondary market means that those early investors can easily take their capital out of an ongoing concern and invest in another start-up venture, thus supplying the market with an IPO at that time and possibly another IPO down the road if the next start-up investment becomes a success. This is a good thing that we as a society should encourage.

It is important to remember that our capitalist system needs capital to thrive and grow. Not only does our population growth need a consistently growing economy to employ new workers but our Social Security system very likely faces a disaster without a larger and more productive economy. Politicians and pundits have always said that our options involving the future of the current Social Security system are limited to lower benefits or higher taxes. We never hear another option; that our population could grow dramatically enough to cover our obligations. That idea makes the Ponzi scheme aspect of the system much more obvious. It is rarely, if ever, considered that our economy could grow enough to cover the future social security obligations. I don’t know why this option is never discussed but I suspect that to many it seems unrealistic.

Traditionally our system has relied on many workers supporting each retiree, that ratio has been going down for years, that ratio is likely to go to ridiculous levels when the baby boomers retire. My suggestion is that we need to grow our economy enough so that future workers are compensated well enough to actually pay for the Social Security program. A necessity to achieve such growth would be much more efficient use of capital. By efficiency I do not mean the selection of winners over losers; competition makes for stronger ideas and ventures. I am saying that the government should be satisfied with a smaller cut from a larger pie when the investing public reallocates their capital.

I have only scratched the surface of this subject and I plan to write on this and other economic subjects in the future. I especially plan to write on the strange idea that the strong economy that we experienced in the ‘90s was due to tax increases earlier in the decade; a meme that I have described as Rostenkowski economics. The lesson that allows one to understand why the tax increase equals booming economy nonsense is actually a meme lies somewhere between understanding Economics 101 and understanding the bond-desk at Goldman Sachs; so it may take a while to work it up.


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