Taxes on Capital and Capital Accumulation

Taxes on Capital and Capital Accumulation
October 12, 2014

An economy is, fundamentally, a physical thing. We create goods and services. We don’t create “money.” Money, and all the associated contracts such as debt, equity, and so forth, are really ways of organizing human activity to produce goods and services.

Today, in the industrialized economy, we have enormous investments in capital. “Capital” is, fundamentally, the creation of a thing that helps to create goods and services. Actually, it doesn’t even have to be in the form of a physical object, but could be in the form of knowledge and expertise. For example, a biotech company will invest millions to do drug research. In effect, they are creating knowledge, the knowledge of how to create a certain sort of drug with a certain sort of effect. On a more personal level, you could invest a lot of time (and money) learning to become a high-end restaurant chef, which allows you to create a valuable good/service.

March 30, 2008: The Capital/Labor Ratio

On a more physical level, we invest in the things we need to create goods and services, the basic plant and equipment. This is the “factory” and “spinning machine” or “power shovel” in typically archaic examples. It also includes things like buildings and property to provide services. Starbucks doesn’t just sell coffee. The company also requires a lot of investment in buildings and structures.

This “investment” is the flip side of “savings.” “Savings” means that we produce but do not consume. This creates a surplus. This surplus is directed toward creating things which have a long life, and which can be used in the process of creating more things. In practice, “consumption” and “investment” are somewhat arbitrary categories. For example, a laundromat might have to “invest” in washing machines, but if a person buys their own washing machine, that is “consumption.” Likewise, a car rental agency “invests” in a car fleet, but if a person buys a car, that is “consumption.” You could say the same of rental housing vs. owned housing. Nevertheless, we have the idea that “consumption,” the most basic form of which is actual food, has a short life and quickly disappears, while “investment” has a longer life. If we “invest” a year of time to build our own house, we then have a nice house to live in for thirty or more years, instead of living in a hut made of twigs. The fact that we can live in a nice house instead of a hut of sticks makes us materially more wealthy. Thus, the investment leads to material wealth.

Thus, everything in our economy which has some meaningful lifespan, which is not immediately “consumed,” is a sort of capital. This includes things like roads and buildings. For some reason, we tend to forget that. However, there is a bit of distinction between things that are simply enjoyed in their present state (such as a residence), and things which are used in the process of making some other good or service, and are not of much use otherwise (an office building, or any sort of machinery or other capital good which cannot be used as a final end product, such as a natural gas drilling rig).

It is sometimes said that “capital” is time and energy of humans. In some sense, there’s no way it could be anything else. That’s the only ultimate resource we have. The idea is that, instead of using time and energy to create something that is quickly consumed, leaving nothing, we instead direct that time and energy to create something of lasting value — particularly, something that allows us to then create other goods and services. We can see that a “high level of capital investment” means, ultimately, the direction of a large amount of human time and energy to create “capital goods” instead of “consumer goods.”

For example, let’s say that you can have a spinning machine (don’t you love these circa-1810 examples) which allows one person to do the work that had previously been done by 20. However, if you have a low amount of capital investment, for example if there are 1000 workers in total but you buy one spinning machine per year, then obviously the output per worker still isn’t going to improve very quickly. If you have a high level of capital investment, and buy 500 spinning machines per year, then the output per worker increases tremendously. But, where do these spinning machines come from? If you are buying 500 spinning machines per year, then obviously, someone somewhere is making 500 spinning machines per year, instead of just one. Thus, the resources of the society are directed towards creating and putting to use 500 spinning machines per year, instead of just one spinning machine per year. These spinning machines are “capital investment” and also “savings,” because the people making the spinning machines are not, instead, using their time and energy to make goods and services for immediate consumption. Thus, the reduction of “consumption” and increase in “savings/investment” by the household translates into the reduction of production of goods/services for consumption and the increase of activity to create capital in the real world.

We “create capital” by “savings.” What this means, in practical terms, is that we work to create things which we do not immediately consume. There’s something left over. Let’s say we have 1000 people. This 1000 people agree to devote 20% of their time to create things of lasting value for their community, particularly things which then allow them to create more consumable goods and services. For example, maybe they clear some land for growing food. This effort allows them to grow more food in the future, which is presumably a desirable thing (or else why spend so much effort to do it), which thus makes them materially “wealthier.”

This is a fairly common line of thinking, so I will leave the rest of it to the reader. The point is, our “financial” investments, savings and so forth translate into real-world human activities. It’s actually the real-world activity which makes us more or less prosperous … in the real world.

The better economists have long understood that “accumulation of capital” is a core element in the process of making a society more wealthy via the capitalist industrialization process. For some reason, we don’t focus on it that much today, which is a problem.

But, today’s discussion is about how taxes affect the accumulation of capital. In particular, how do taxes on capital, such as capital gains or dividend taxes, or inheritance taxes, affect the process of real-world direction of human activity in channels which increase real-world material abundance?

The process by which “savings” becomes real-world investment is basically via either debt or equity. A business or corporation (virtually all businesses of any meaningful size are a corporation, including one-person LLCs) either issues equity or borrows money. This equity and debt is the “savings” or wealth of the saver. The money flows from the saver to the investor (corporation), to fund the creation of new capital investments. As the corporation spends the money it has obtained either through equity or debt, it employs people to do one sort of thing or another, or purchases products which were in turn created by people. Thus, in this way the actions of humans are directed toward real-world capital creation.

Obviously, this happens on a “flow” basis you could say. In any one year, there is so much savings and so much investment. Debt and equity is created. Now let’s say that equity (for example) trades hands on the secondary market — in other words, in the “stock market.” Prices go up and down. The secondary market has nothing to do with the issuance of equity by corporations, which is what really finances real-world investment. If you buy 1000 shares of ABC for your 401(k) portfolio, in the secondary market from another investor, this makes no difference to the ABC corporation (which is not issuing new equity). Thus, it would seem that the real-world effect is zilch. If you then sold those shares again, and made a capital gain, and this capital gain was taxed, what difference does that make to the ABC corporation? It doesn’t directly affect the ABC corporation — and its capex plans — at all.

By “equity” I do not only mean publicly traded securities, but ownership in any kind of business. If you open a lemonade stand with your own money, you own 100% of the “equity” in the business. The money you spent to get the lemonade stand up and running was an “equity investment.” Likewise, debt includes bank debt, not just securitized debt.

As the society directs its time and energy into capital investments, it also creates contracts which say who is to benefit from the products of these capital investments. This is the corporate balance sheet. “Investment” creates “assets,” listed (literally) on the asset side of the balance sheet. On the liabilities side, debt and equity shows who owns or gets the benefit of those assets.

Imagine that you aggregated all commercial activity into one giant balance sheet. On the “asset” side you would have the assets of all businesses. On the “liabilities” side you would have all the debt and equity in the economy (or world).

What happens when you have taxes on capital — in other words, the things on the liabilities side? These would include wealth taxes, capital gains taxes, taxes on interest income and so forth. I would distinguish between two kinds of taxes on capital: taxes on “stock,” and taxes on “flow.” A business generates cashflow. This ultimately ends up, from an investor’s standpoint, as either dividends or interest. (Corporations also reinvest cashflow, on the behalf of equity investors.) Quite often, these dividends or interest are reinvested, which means new savings for the economy, and thus more capital investment. I would guess that dividend and interest income has a higher rate of reinvestment (“savings rate”) than employment income. So, if you tax them, you have less savings.

However, taxes on “stock,” such as wealth, inheritance or capital gains taxes, are a little different. If I buy some stock for $100 and sell it to someone else, in the secondary market, for $200, and that $100 gain is taxed, what happens? Or, if I die and the government takes $50 of my $100 stock portfolio in inheritance taxes, what happens?

To make a long story short, I conclude (for now) that this amounts to “negative savings.” For example, let’s say I buy some stock for $100 and sell it to someone else for $200. The government taxes my $100 gain at 20%, leaving me with $180 in total. This would seem to have no effect on the corporation, and thus no effect on the process of real-world capital accumulation. However, look at the person who bought the stock from you. Let’s say they accumulated $200 of savings (from not spending their income) during that time period to buy your stock from you, for their 401(k) plan for example. Now they have your stock and you have $180. $20 of savings ended up in the hands of the government. There is only $180 left.

Another way of looking at it is this: Everyone already owns all the existing debt and equity. So, if there is $1000 of new savings to invest, that must ultimately be matched with some kind of new debt or equity. In other words, the new $1000 flows to the corporation for investment in the real world. However, let’s say there are some wealth taxes. Inheritance taxes require the sale of 50% of accumulated debt and equity, with the cash taken by the government. In aggregate, the government takes $500 (total tax revenue), which must be funded by the sale of assets. These assets have to be sold to someone, which is the new savers with $1000. Thus, of their $1000, $500 goes to buy the assets sold by the inheritors (a simple changing of ownership), leaving only $500 to flow to corporate investment. From a cashflow perspective, things have to balance out. Cash out to the the government must be matched by cash in from somewhere, and it is clearly not from corporations.

People have long had the sense that taxes on capital are particularly destructive of the capitalist economy, compared to their typically modest revenue. Our discussion even ignores, for now, the very large subject of incentives. In general, the importance of high savings and high investment has not been properly recognized in recent years. There’s another discussion also related to “savings” which goes to fund consumption, not investment, and thus results in no new accumulation of productive capital. This would include especially consumer lending, and lending to the government. If you consider today’s low savings rates, high levels of government borrowing, high levels of household borrowing, and the effects of taxes on capital, there isn’t a lot of productive investment at all going on it seems. Consequently, there isn’t a lot of job creation, at least of the high-paying jobs that reflect high levels of capital investment. There is still job creation, because people without a job will have to somehow create one for themselves (basically by being willing to work at a low-productivity job, for a low wage). But, it typically results in a high degree of “underemployment.” For example, let’s say there are 1000 workers but you only buy one spinning machine per year. All 1000 workers could potentially use a spinning machine, but they just aren’t available to them due to low capital investment. The other 999 workers have to do something, and since they don’t have a spinning machine, they get to sweep the floor.