Capital Gains Taxes

Capital Gains in a Supply Model is a speech (statement) given by Jude Wanniski before the US Senate Finance Committee on Wednesday, February 15, 1995. It contains one of the best explanations of capital investment in general (stocks, bonds, loans, etc.) that I have ever heard - especially since it is a very personalistic (which I usually shy away from because of my temperament) piece of prose. Consider the following:

"In the kind of capitalism we have here in the United States, people invest in each other. People with capital invest it in people without capital. Old people invest in young people. Rich people invest in middle-class people and the middle class invests in poor people with promise. People in cities invest in country people, and farm people in town people. When all this activity is at a high level, the economy is too."

The funny thing is, the point of the speech is not to explain the nature of capital investment, nor to argue for its ethical rectitude, etc. Rather, the point is to argue that the government tax rate on capital gains should be zero.

His rationale (if I may take the liberty of abstracting a bit) is that, when the government taxes something, e.g., taxing the act of purchasing an item (sales tax), taxing the act of owning a house or car (property tax), taxing being a productive member of society (income tax), etc., or, more precisely, to the extent that the government taxes something, the government thereby discourages that activity. For instance, if I am considering buying a new car that costs $10,000, I will be much more likely to do it if I will get charged 1% sales tax than if I were to get charged 15% sales tax. Likewise, I might not buy it if I will be required to pay a 10% property tax each year. In short, taxation is an instrument of dissuasion - an economic deterrent (as opposed to incentive) - perhaps not per se, but certainly per accidens.

Thus, when you consider whether or not it is prudent to tax a certain activity, one of the key questions ought to be "is this activity either (a) such that it should be discouraged (perhaps only under specific circumstances) or (b) such that it would not be imprudent or overly detrimental to discourage it (perhaps only minimally)?" If the activity in question is a very beneficial activity both for individuals and for society, one would have to present rather compelling justification for discouraging it (even indirectly) via taxation.

To the point of this post, then, capital investment, Wanniski argues, is one of the driving activities of our economy. It is how the market dynamically allocates resources where needed to maximize efficiency and production, while, at the same time, providing a beneficial financial instrument to the owners of the surplus resources. In other words, everyone wins: those who lend money get a return on their money which would otherwise be sitting under a mattress literally losing value due to inflation, and those who receive the money benefit by being able to engage in productive and profitable activities that they would otherwise not be able to perform due to lack of start-up funds.

Thus, Wanniski asks, should we discourage this activity by taxing the gains returned on the lent money. All that does is discourage people to engage in capital investment in the first place, which stunts economic growth by misallocating resources (away from new enterprises and to the space in between the box spring and mattress).

I recommend reading the entire statement - it's only a few pages long and worth the read.