Client Q & A Jude Wanniski November 5, 1991

Q. You compare current tax policy to winning $4 (after tax) on a $2 bet for a 40:1 long shot win. Capital gains tax — inflation adjusted — in your example is confiscating $76 or 95% of all pay offs. But as I understand capital gains today, the confiscation is much, much less. A $2 venture capital investment growing to $80 in five years would leave a federal tax of about $21.84 on sale (i.e., 28% of the $78 gain) leaving the player with $58.16 This is a 96% after tax internal rate of return which seems worth taking a few risks. Inflation at 5% would have increased the $2 a whopping $0.55 (from $2 to $2.55) in a safe five year government bond portfolio. This leaves an after tax inflation adjusted payback of $57.61, substantially richer than your $4 example. What do you say?

A. The problem with your example is that you assume your 40-to-l shot won. In real life, as a horse player, you have to make forty bets of $2 each on forty longshots to have a probable chance of winning $80 on one of them. If you bet $80 with a chance of winning $57.61, you are facing discouraging odds — the equivalent of having seven zeroes [house slots] on a roulette wheel. To have to wait five years before you find you have won or lost is even more daunting. You are better off going to a real race track, going to Las Vegas, or playing the lottery, which at least saves you five years of worry over your investment. There is no tote board for venture capital in small, start-up businesses, so the rate of return has to be imputed by the investor [in aggregate, the financial service industry as a whole]. The mistake in your question is precisely the error the mathematical models of the economy make in assessing the impact of capital gains taxation: Because models cannot quantify risk-taking, they treat a stock as if it were a bond, where the "win,11 and the "payoff" is known at the time of investment.

Q. Pension funds — the largest source of all types of investment capital — don't pay taxes at all. What effect does this have on your capital gains argument?

A. The largest source of start-up money for an enterprise is the individual's own assets, the equity on a home or loan from a parent or rich uncle. If you have an idea for something that someday might be called a personal computer, and need $10,000 so you can work on it at night in your garage, you will not find the capital at a pension fund. This pension fund venture capital waits until the race is more than half over, placing bets on the five horses in the lead, rejecting the 35 who are straggling. If you, as a participant in the pension fund, must withdraw assets from the fund, you must of course pay the taxes on the gain. The pension fund itself, in selling its ticket on a horse into the market, must sell to a player who must himself pay tax rates on capital gains. This, too, affects the price of shares on all the horses.

Q. If we're trying to encourage new investment, why shouldn't capital gains tax cuts apply only to new investments? If you want to help new entrepreneurs, why not just eliminate the capital gains tax for non-millionaires?

A. If you wish to start a new country, the proposal would be correct. As there is no capital in the USSR, the idea of only freeing new investment from capgains taxation would be appropriate there. But, in the United States, a mature country, all of the nation's capital in private hands has been accumulated in the past, and is a rich source of funding for new enterprise. To say that capital must face a confiscatory tax before it can be freed for this purpose puts us in a slightly better situation than the USSR, but not much. The most dynamic economic growth would result from elimination of capital gains taxation.

Q. If zero tax is so good for capital, why not for labor?

A. There is almost no risk associated with ordinary income. You go to work on Monday and you are paid on Friday. You and the employer know the pre-tax cost and after-tax reward for labor. Some tax on ordinary income can be optimal. A zero tax on labor should apply at the apprentice level, where greater risks are involved. The income tax should not apply, here or in any country, below the level of the journeyman worker. This was the concept when the progressive income tax was begun in 1913. Prior to the inflation of the last quarter century, a household of four did not pay income tax at all until it reached an income of what today would be an annual rate of $35,000.

Q. If we don't get a growth package next year, what happens to the stock market?

A. Everything else being equal, it should stay as flat as the economy. If the Fed caves in to political pressure and inflates, the market will nosedive. If a growth Democrat emerges to challenge President Bush, and the market can discount definite relief in '93, the market should be strong.

Q. [From a client in London] You say the capital gains tax in the U.K. will be cut after the next elections. There is absolutely no way I can see that happening. Prime Minister Major is raising taxes left and right, putting the VAT up to 17.5% from 15%, and government deficits are growing fast. The Labor Party has committed itself to raising the top income tax rate to 60% if elected, i.e., a 50% top rate instead of 40%, plus elimination of the earnings cap on the 9% health tax. You have got to be wrong.

A. Major has been bungling. You are right about that. The distress in the U.K. economy may get to the point where it is impossible for the Tories to win, in which case we will not find out if I am right or not. We expect elections next spring. If the Tories win, I believe it highly likely, if not almost certain, they will spring a capital gains surprise. There is no discussion in the British press about this possibility, but there is in the underground.

Q. Are you not happy now that Boris Yeltsin has decided to plunge ahead with radical economic reforms, lifting price controls by the end of the year, etc.?

A. The strategy Yeltsin has adopted has been designed by The Forces of Darkness in alliance with Harvard. It is evil. It will cause incredible stress across eleven times zones, far worse than anything being contemplated. Freeing ruble prices, before fixing the value of the ruble itself, will wipe out virtually all of the private capital stock of the USSR. In Poland, where the Harvard-designed monetary shock has left the economy in shambles, at least there is a significant stock of private capital that survived the inflation and can be collateralized for start-up enterprise. In the Soviet Union there will be none that will survive. The USSR horse race will begin in earnest with 300 million horses and no bettors in the grandstand, which means the track will have no purse to offer. At least until the collectively held capital stock can be transferred to private hands, the situation will be unique in the history of civilization. It is the jungle, pre-civilized. I've received a letter from Ambassador Bob Strauss in Moscow, who tells me he has circulated my idea of fixing the ruble first, but that he can find no interest in it. I'm afraid he dines with the Harvard crowd. I am very, very worried about what will happen early in '92.

Q. Are you still bullish on Mexico? What is the downside there?

A. The Salinas government is three years old. The audacity of its economic team, which has been responsible for the economic expansion and explosive growth of the Mexico City stock market, may be on the wane. We detect a tendency among some of the policymakers in the government to be happy enough to "sit on their lead," postponing policy reforms on taxation, money and regulation and contemplating a balanced budget. In Mexico City last week, we met with several of these officials and told them of our concerns. They cannot become the next Japan, or even Taiwan or South Korea, if they are content to grow at a mere 4%. We got some promises of a brisker pace of policy reform, and hope that our worries will be put to rest shortly. I'm returning to Mexico City November 25 to meet with President Salinas, especially to discuss their future economic plans.