One of the most prominent canards in the economic literature involves the concept of converting ordinary income into capital gains. Most academic economists teach their students -- as they themselves have been taught -- that clever taxpayers find ways to do this to take advantage of the lower tax rates that have traditionally been associated with capital gains. The next step to this argument is that capital gains should be taxed as if they were ordinary income.
In fact, it is not possible at all to convert ordinary income to capital gains. In order to get a capital gain, ordinary income must first be earned, then taxed, with the untaxed remaining portion invested in debt or equity. All capital gains, everywhere, are the result of a successful investment of ordinary income that has been taxed. Several years ago, I was among those who believed that the optimum capital gains tax would be something close to 15%, as my own supply-side teachers believed that to be true and taught me a lower rate would invite inefficient conversions of ordinary income to escape the higher tax on ordinary income. Two people persuaded me that the correct rate was zero. One was Ted Forstmann of Forstmann, Little & Co., one of the true financial wizards I have known. The other was Alan Greenspan, who labored in the Wall Street vineyards before he got his academic degrees in economics. He told me he had spent decades trying to figure out how to convert capital gains to ordinary income, and couldn't figure out how to do it. As he put it in a conversation in his office at the Fed, perhaps a decade ago, any tax on capital gains is a tax on the national standard of living. It was Forstmann who made me see that the political forces who oppose a lower capital gains tax are those who have already acquired their wealth. I found confirmation of this view in the writings of Karl Marx and Ludwig von Mises, on the left and on the right, both of whom observed that people of wealth have a natural inclination to protect that status by using the tax laws to discourage those in lower stations from climbing into their ranks.
A lower capital gains tax cuts in the opposite direction. It encourages people who have a surplus of capital to invest it in people who are short of it. This does not mean that rich old white men or their widows, who possess most of the nation's wealth in their holdings of financial assets or real property, will travel into the South Bronx to look for the worthy poor who would like to be staked to enough capital to buy a pushcart, with the dream of someday opening a hamburger stand. That's not the way the market works. When the government increases the reward for the successful investment of capital, more capital is offered to the market. Indeed, capital is created as if it were being pulled out of thin air. This is because "capital" is simply the excess time, energy and talent of individuals in the economic system. If there are only two producers in the system, Jones on the south side of town making bread and Smith on the north side of town making wine, should they come together face-to-face, they can come to terms on the trade of their maximum output. If Jones finds a more efficient way of making bread, he does not change the terms of trade to give Smith more bread for the same amount of wine. He reduces the time he spends making bread in order to meet the terms of his contract. He has surplus time, energy and talent left over. If another party appears in this market selling apples, Jones can acquire them by producing more bread, but Smith will have to become more efficient in order to have a surplus to trade.
Now magnify this picture into a modern economy. There are 125 million "workers" producing things. With the average work week perhaps 40 hours, the amount of weekly hours available for producing bread, wine, apples and all other goods and services will be 125 million x 40 or 500 million hours of labor. Fed Chairman Greenspan worries night and day that without new workers available to produce the extra hour of labor, the price of labor will rise throughout the system in terms of dollars per hour. He really has nothing to worry about, though, as long as he does not create surplus dollars. As long as the dollars in the system exactly meet the demand for dollars at a reliable reference point -- the dollar price of gold being the tried and true point, even by Greenspan's lights -- the 500 million hours of labor will have to be paid out of the existing stock of money. There cannot be an "inflation" by a shortage of labor.
Conventional demand-side economists will argue that at full employment, which is where they believe we are today at 500 million hours per week, a lower capital gains tax will put more money in the hands of the rich and they will drive up the price of labor by buying more luxuries. The Treasury's Mr. Burman instead would suggest that taxing capital gains at 39.6% instead of 20% would make the economy more efficient by taking this surplus money from the rich and using it instead to pay down the national debt. Microsoft's Bill Gates might even agree, now that he is worth so many tens of billions of dollars that it does not concern him that shares he sells in order to meet living expenses pay a capgains rate of 39.6% instead of 20%. Indeed, he need not sell any shares to meet living expenses, but can give away $5 billion at a chunk, as he has this week to the Gates Foundation, without having to pay capgains tax or income tax for that effort. Meanwhile, Microsoft's Slate magazine is edited by Michael Kinsley, who believes that capital gains should be taxed as ordinary income, and the economist emeritus is Herbert Stein, who encouraged Richard Nixon to raise the capital-gains tax in 1969. Most of you will know Herbert Stein's son, Ben, as the host of a popular TV game show and the fellow who made fun of "supply-side economics" in the movie, Ferris Bueller's Day Off.
What really happens when the capital-gains tax comes down toward zero, its optimum level, is that the 500 million hours of labor available can be channeled into riskier enterprises, because the reward to successful risk-taking has increased. In the economic system, the baker can afford to risk acquiring a new bread-making machine, on credit from the company that makes bread-making machines. Instead of laying off bakers when the bread-making machine arrives, he can make more bread. The winemaker also can risk making more or better wine, if he has surplus time, energy or talent, or can find it offered to him by someone else who would like to invest in an expansion of the winery. There is no need in our economy for new inventions or new technology from the Internet to cause this general increase in the general level of economic efficiency. We are at this point only talking about ordinary people using existing technology. The Internet is gravy, in the sense that the U.S. economy has the capacity to grow much more rapidly than it is simply by removing barriers to normal growth of ordinary workers.
This has to be true, of course, otherwise how could one explain why poor countries can't seem to grow faster even when they have all the technology in the world available on the world market. In the Asian subcontinent, there still are Indian peasants who use wooden ploughs and Pakistani bakers who still knead by hand. In most cases, an examination of the tax structure in poorer countries will show that capital gains is taxed lightly or not at all. It is the incomes of people in the former colonial countries that have been taxed at such oppressive rates for the last century that the poor cannot accumulate after-tax income to invest in risky ventures -- which is the only way to get a capital gain. In India in 1975, as I wrote in The Way the World Works two years later, the top marginal income-tax rate was 97½% at a dollar-equivalent income of $25,000 a year. The capital gains tax was zero, but the economy had been killed long before it could produce taxable capgains in any case. In the years since, income-tax rates have come down, but the practice has been to enact capgains taxation and increase the rate toward ordinary income tax rates.
Sometime before I wrote TWTWW, I recall being on a flight seated next to an Australian farmer prosperous enough to be traveling in the States in first class. I asked him how he could survive in a country with confiscatory income-tax rates. He replied that he really did not pay much tax. He lived on the production of the farm and took no profits that could be taxed as income. All profits were ploughed back into the farm as capital investments that made the farm more valuable. When he would have it as loaded as possible with the best fences and irrigation and capital equipment, he would sell the farm and pay zero capital gains tax on the total amount received. Throughout the former colonies of the British empire, this was standard practice, which is how the idea of converting ordinary income into capital gains becomes part of the literature.
But look closely and you will see that the only way the Aussie farmer could avoid tax on ordinary income was by putting it at risk in capital outlays. He could not use it to enjoy the fruits of his labor because it had not been put through the income-tax gate. He believed that there would come a day when he could sell his farm and realize the gains as wealth that could be converted to consumer goods of his liking, but if the government instituted a capital-gains tax meanwhile he could be screwed, or if the market for farm commodities declined when he was ready to sell, he was screwed, or if the market shifted away from the commodities he produced to other commodities, his capital equipment would have less value and would not bring a fraction of what it cost him.
In another example I wrote about in TWTWW (which you should all have read by now, by the way), I discussed the success of the NAZI economy under Adolf Hitler in the 1930s. Keynesian economists to this day continue to point to Hitler's spending on public works and military expansion as the key to the economic success of national socialism. Upon supply-side examination of what really happened, I studied the policies of Hitler's Finance Minister, Hjalmar Schacht. Where much of the world had tangled itself up in protective tariffs in response to Herbert Hoover's Smoot-Hawley Tariff Act, Schacht worked out reciprocal trade agreements with 25 countries that produced raw materials, paying them with credits they could use to buy German finished products. This eliminated the tariff wedge on both sides of these transactions, and because the raw materials had to be delivered first, Germany was on the positive side of the credit contract.
Schacht left the high income-tax and corporate-tax rates that had been enacted by the previous government, which collapsed the economy and brought Hitler to power. The one change he made was to permit Germany industry of a minimum size to avoid the corporate tax by reinvesting profits and permitting shareholders to sell assets without payment of capital-gains tax. This kept wealthy Germans satisfied, but the limitation on size for the purposes of promoting "efficiency" kept smaller companies from competing with the big guys. Jewish shopkeepers got no breaks at all.
This method of favoring the big guys over the little guys has been a fact throughout the history of civilization. Much of Latin America, colonized at one time or another by European powers, retains these oligarchical systems to keep the elites entrenched. I've been pointing out for many years that one of Mexico's worst features is the zero capital-gains tax on equities traded on the stock exchange, while everyone else pays ordinary income-tax rates. This is real country club politics. Capital cannot flow from the top to the bottom, so the people at the bottom have not much chance of getting to the top. This is perpetual social stratification, which keeps the "Spaniards" in control and the Indians controlled. I've tried to persuade the so-called populist parties to promise elimination of the capgains tax to the ordinary people of Mexico, but they have been persuaded by the elites that a low capital-gains tax favors the rich, not the poor, so there is no political solution to the problem.
The only way to get the capital-gains tax reduced in the United States is through elevation to power of non-Establishment candidates, or fear by the Establishment that they will lose power unless they permit a little bit of capital to flow to the bottom. As an institution, the Democratic Party has become an Establishment Party, discovering campaign finances will sustain it as long as they support corporate socialism in the Schactian mode of the 1930s. The Republican Party feels the pull of the Establishment as well, which is why it has such a difficult time cutting tax rates on income or capital formation in an era of surplus. In 1988, George Bush won election as President although he was the embodiment of the GOP Establishment. He promised no new taxes and a cut in the capital-gains tax to 15% from 28%, but once elected, his Establishment friends talked him out of both promises. It is highly unlikely that the younger George Bush, now the explicit candidate of the GOP Establishment, would deliver on a zero capgains rate, much less the 15% his father promised in 1988.
In this lesson, I mixed in some politics with the economics, it being necessary for you to learn why economics cannot be learned in a political vacuum. Of all forms of taxation, capgains is the most sensitive politically, because it has the greatest potential for producing social change. Establishments are for the status quo, not for social change.