Capital Gains
Jude Wanniski
November 21, 2003


Memo To: SSU Students
From: Jude Wanniski
Re: Capital Gains in a Supply Model

I had not planned on discussing capital gains this week, but as I noted in a memo posted this week on Governor Schwarzenegger, the topic will be a live one as California confronts its financial problems in 2004. The chairman of the House "Zero Capital Gains Caucus," Rep. David Dreier [R CA], has indicated the new governor would support a capgains tax rate lower than the state's current 9.3% as part of his strategy to deal with the fiscal crisis through economic growth. What I'm presenting here is a statement I gave before the Senate Finance Committee in 1995 when it was chaired by Sen. Bob Packwood [R OR]. I'd completely forgotten about it, but it showed up in a new book on "Welfare and Poverty" by Michael Tanner, who quoted from it in support of the idea that those who benefit the most from lower tax rates on capital gains are those who have no capital, the poor, not the rich. I append a comment at the end of the statement.

A Statement before the Senate Finance Committee
by Jude Wanniski
Wednesday, February 15, 1995

I can not begin to tell you, Mr. Chairman, how thrilled I am to be before this committee to address the topic of capital gains taxation -- especially having been informed by staff that you had requests for my testimony from both sides of the aisle. As you know from personal experience, I have been a "nagging wife" on the critical importance of this issue for several years, to the point where members of Congress or the Executive Branch cross the street when they see me coming. If you will recall, Mr. Chairman, I had you in my clutches in 1989, in the earliest days of the Bush Administration, at a point where you were dead set against any change in capital gains taxation. I would like to think I had something to do with having you reverse yourself to the point where you are now as persuaded as I have been that there is no single thing we could do in fiscal policy that would energize our economy as much as a lower, indexed capital gains tax.

Since that milestone conversation I had with you in 1989, in Boca Raton, Fla., I've had a further epiphany on this issue, which I will make the centerpiece of my testimony today. It began with a conversation I had four years ago with Alan Greenspan, who told me of his belief that the correct tax on capital gains is zero. His position, which he has since made parenthetically to the banking committees of this body and the other when testifying on monetary matters, is that a tax on capital gains is a tax on the national standard of living. My epiphany was completed a few weeks later, in a conversation with Ted Forstmann, who may well be the most successful entrepreneurial financier of our time. It was Forstmann, now a man of immense wealth who began his career with nothing more than a good education at Yale and a trust fund that provided him $500 a month, who let me in on a secret. Men of wealth, he told me, are not interested in a lower capital gains tax, because their gains are behind them. The people who benefit most from a lower capital gains tax, he said, are those who have no wealth, but aspire to it. Independently of Greenspan, Forstmann told me the correct tax on capital gains is zero. What we are talking about here is the essence of capitalism, which is why this has become the defining economic issue of the Republican Party.

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.

When Wanniski invests in young Forstmann -- directly or through a bank, a credit union, a stock market, a thrift, an insurance company or a pension fund -- and Forstmann succeeds, I get to share in the fruits of his success. The more successful he is, the more I get in return. If he loses, I lose. Now, if the government tells me that if Forstmann succeeds, I have to pay Internal Revenue a high percentage of my share of his success, I will think twice about making the investment in the first place.

If Forstmann Inc. looks like a sure thing, I might invest in it anyway, but if he does not have a proven track record in business, I will pass and Forstmann, Little & Co., may not get off the ground. I will invest in a blue chip company, or a government bond, or a municipal bond, something safe.

When the capital gains tax is high, riskier investment in the young and the small and the promising, aspiring poor will dry up. People will stick close to home, which they know best. City people will not invest in country people and vice versa. And because there are fewer people able to try for success, there will be less success for the country as a whole.

When the capital gains tax is low, and there are more people encouraged to invest in each other, there is also a lot of employment. People who start a new enterprise with new capital hire helpers, and whether the enterprise eventually succeeds or not, the workers are earning weekly wages and paying taxes -- not only income taxes to the federal government, but taxes of all kinds to state and local governments.

People on unemployment benefits and welfare rolls are employed and begin adding tax revenues to City Hall and the county and the state, instead of living on public welfare.

All of this activity, remember, is occurring because someone with capital -- by which we mean surplus energy, talent and time -- is willing to bet on another person, who is temporarily short of either energy, talent or time or all three. The payoff for success in the venture is called a capital gain. Failure is termed a capital loss.

It's bad enough when the government puts a high tax on capital gain, because the people who lose the most from a high rate are the poorest, the youngest, those at the beginning of their careers, those who are furthest from sources of capital.

But when the government also taxes gains that arise from inflation, not real gains, then the flow of fresh capital from those who have it to those who need it really dries up. If the rate is 28% on a capital gain, but it takes five or ten years for an enterprise to know whether it is a success or not, the investor must consider the inflation rate compounded over those years and add it to the 28%. The rate then becomes confiscatory.

Inflation is a direct result of the monetary or fiscal irresponsibility of government. To penalize participants in the private economy for the mistakes of government seems to me to be the height of arrogance and irresponsibility. In my home state of New Jersey, almost everyone who owns property now has to consider that if they sell that property -- the farm, the home, the business -- they have to pay capital gains tax on what is for the most part an inflated gain.

The price of their property has gone up in the last 25 years, but the value is about the same, in terms of other goods and services that have also risen in price. So they don't sell the property, unless they are forced to sell in distress. The capital is "locked in." It can't be sold to someone who could make better use of the farm or home or business, with the proceeds to the current owner then invested in a new enterprise.

In the entire United States, which is worth about $30 trillion altogether, lock, stock and barrel, about $7.5 trillion -- one quarter of all -- is in value that is pure inflation. The federal government would grab 28% of that if it were sold tomorrow, and state and local governments would grab their pieces too. But because it is almost all "locked in," the government gets almost none of it.

If the government decided tomorrow that it wasn't fair to tax all that inflated gain, it would immediately come unlocked. As it changed hands, governments at all levels would be able to get their share of the real gains. Not only would capital become more efficient, as the economists say. People everywhere would be happier with this great burden lifted from them, economic activity would increase, and governments would find their budgets going from red ink to black.

Imagine you had a race track, where purses were so high for winning races that fine horses came from near and far to enter, and bettors came from near and far to watch and wager on these fine horses. Imagine, then, the government announcing it would tax away most of the purse, and you will quickly see the destruction that is done by the current federal capital gains tax of 28% as it applies to inflated as well as real gains.

This is why both political parties should be dedicated to at least reducing the rate and removing the tax threat on inflated gains. Almost everyone in the country would benefit immediately and for generations to come. The only losers would be those who are now betting on the nation's continued decline and failure.

Why is there such ideological opposition to this idea from the Democratic side? It is because the Democratic Party is the party of security, the party of fairness and compassion and equality. It is like the mother in a family, whose role is to question risky enterprise. The Republican Party must play the role of risk-taker, the traditional husband and father role of enterprise. President Clinton and the Democrats of this committee will naturally be skeptical of ideas that increase the levels of risk-taking in our society. It is up to the Republicans of the committee to persuade them that without risk-taking, there can be no economic growth. I say that again: Without risk-taking, there can be no growth.

All growth is the result of risk-taking, all success is the result of failure. The dynamism of our national economy is dependent upon people who are secure in their wealth, investing portions of it in men and women who have get-up-and-go and a can-do attitude, but no capital. The Majority Leader of the other body, Dick Armey, born in Can-Do, Okla., would eliminate the tax on capital gains altogether in his flat-tax proposal. He is in agreement with Alan Greenspan and Ted Forstmann.

I bring up Congressman Armey at this point of my testimony because of his well-known desire to change the method of scoring capital gains taxation by the Congressional Budget Office and the Joint Committee on Taxation. The reason is not that he would like the computers that do the scoring to be programmed by optimists instead of pessimists. It is rather that they should be programmed by supply-siders instead of demand-siders, as they are now.

In a demand-model, whether Keynesian or Monetarist or a combination of the two, there is no such thing as risk-taking. "Demand" means consumption, just as "supply" means production. All the computers in the legislative and executive branches at the present moment are programmed in the consumption mode, which assumes production is automatic. You have heard the expression many times, "Demand creates its own supply." If all growth is the result of risk-taking and our national policies of public finance are routinely ignoring risk-taking, inevitably all growth will stop.

Can the computers be programmed by supply-siders? Not really. The fact is, risk-taking cannot be converted into mathematical notation. In 1936, the great Princeton mathematician, John von Neuman, one of Albert Einstein's close friends, demonstrated that risk-taking could not be converted into mathematical notation. This meant that economics could not be converted into a mathematical science. It would have to remain a behavioral science. Unhappily, the departments of economics throughout the country, including those at Princeton, chose to ignore Professor von Neuman. This is one important reason why our national economy has become so sluggish, why our national standard of living has been in decline for more than a generation. And here, I quite agree with Labor Secretary Robert Reich when he points to the discouraging decline in real wages over the last two decades. But where Secretary Reich would get us moving again by spending more federal money on training workers for jobs that do not exist, I would eliminate the capital gains tax, stand back, and watch the boom unfold.

Now do not get me wrong. Cutting or eliminating or indexing the capital gains tax is not the magic bullet that solves all problems. It is, as Jack Kemp has been saying for years, "the bone in the throat of the national economy." Unless that bone is removed, no amount of pills or surgery aimed at treating the rest of our body politic will do much good. As long as risk-taking is punished, growth will be smothered.

In 1989, I was invited to Moscow by the central bank of the Soviet Union, to advise them on how to convert to capitalism. The bone in their throat is not excessive taxation, but the absence of a reliable money, which is a prerequisite to a financial industry and a market economy. They took the shock therapy advice of the IMF and are still experiencing economic and political chaos. In my several visits, I would use the following metaphor to give them a feel for capitalism:

Imagine three countries in the world, each of which produces all its GNP by digging holes in the ground. In the first, the workers dig with backhoes, in the second with spades, in the third with sticks. I would ask in which country will the workers have the highest wages. Obviously, the difference is capital. You can take a 25-year-old man in the United States or one in Poland or one in Ethiopia and give them a shovel and they will dig approximately to the same depth in the same amount of time. Capital makes the difference. Secretary Reich can train all our young men to work backhoes, but if all that is available are sticks, the market will pay them the minimum wage.

This, though, is why I would happily support an agreement with the President, to raise the minimum wage at the same time we index and reduce the capital gains tax. Real wages would rise without an increase in the minimum, but if the administration insists on the tradeoff, I would see almost no harm in it. The only serious damage would occur in Puerto Rico, whi. ch has its own tax structure, but which is obliged to meet the mandates of our minimum wage law. This could be resolved by suggesting to Puerto Rico that it match our adjustments in capital gains taxation, something I have been trying to get them to do anyway.

These are broad, general observations, Mr. Chairman, as I can only hit high spots in the time I was allotted for a prepared statement. As you well know from my nagging, I could sit here until the cows come home answering questions about this issue. I would be happy to supply the committee with answers to any questions you may have. I would be surprised if you come across a question or criticism that I have not confronted in the last several years. I genuinely believe we will open the 21st century without a tax on capital gains, as we opened the 20th century. The only question is what path we will take to get there and how fast we will travel it. Thank you again for the invitation to testify on this most important issue before this most important committee.

* * * * *

As you see, I was wrong about entering the 21st century without a tax on capital gains, but we did get it down to 15% from 28%, where it was at the time of my testimony. There was a lively Q&A session that followed my statement, but I can't locate that transcript at the moment. Perhaps one of you can find it in on the internet... I do remember being challenged by one member of the committee, then Sen. Carol Mosely Braun [D IL], who is now running for the Democratic presidential nomination, and presumably still opposes cuts in the capital gains tax.