Of Punters, Entrepreneurs and Distortionary Taxation!

Abstract:
Market Investors are Not Entrepreneurs. Neither Entrepreneurship nor Investing Is helped by Distortionary Differential Taxation, Which is often one of the Root contributors of Malinvestment Bubbles. Uniform Taxation is the Least Distortionary.
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It is a valid argument that taxation causes distortion in the market. It can skew investments, consumption and work-specialization decisions in particular directions that capital holders, consumers and potential workers might not have taken if there were no taxes. So, tax policy and interest rate policy have been held as the cause of many investment and asset bubbles. The most recent of these has been the leveraged home ownership bubble.


It is not the assertion of this writer that tax policy does not distort and cannot contribute to bubbles. Yet the business of running even a lean, pointed, efficient, unbureaucratic Government raises the need for taxes.

  

And not just taxes, but any kind of Government tinkering with either the natural return or risk from a proposed venture or activity (like working as a Java programmer) is distortionary.

The next best, least distortionary scheme, to no taxes, is bearable taxes that are UNIFORM across how you earn your income. That is, all income is treated the same way, be it payment for work or an appropriation of business profits, or capital gains.

A bogus argument one comes across ever so often is that 'entrepreneurs need lower taxes than others to get encouraged to start a business, so the Capital Gains tax ought to be lower than taxes on work income'. This thought is wrong on many counts:

1. First off, entrepreneurs get into business for the thrill of running their own show and for making much more money than in a job, even if that implies they pay more tax (obviously you should expect higher tax bill on higher income!), and not as a tax hedging strategy. To even think of the latter case is a hopeless academic drawing.
2. Further, Punters in securities (stocks, Gov and corporate bonds included), home prices et al are no entrepreneurs. They know that they are playing the 'greater fools game' especially in stocks, as eventually every stock will typically go to zero when that company fails. The hope in stock and bond investing is that "I will get off before this entity bites the dust (or chooses to default - in case of Sovereign bonds)."
3. If the Government has to take the responsibility to shore up the returns in a business so the entrepreneurs-to-be can create jobs by Government provisioned Risk-Return trade offs, then what the heck we need entrepreneurs for!? We might as well get some job creation directly by bureaucrats openly nannying these created businesses, cut these middlemen (er, 'entrepreneurs') out then. How's 'make business' of the sort the pseudo pro entrepreneurship types demand better than 'make work'? I would imagine that it is WORSE, in that 'make business' is costlier, on count of having to fund the middleman (aka the 'entrepreneur').
4. Government trying to provide lower tax rates for income from market assets vis-a-vis other income types is more distortionary than uniform taxation of different income types. Government should stay away from changing the natural risk-return profile of contemplated ventures and asset bets. The least distortionary thing is to uniformly tax all income types, and not encourage one over the other.

Another argument often heard is that a lower Capital Gains tax (compared to tax on other types of income, such as hard work) encourages availability of Capital at lower cost to entrepreneurs looking to Go public to scale up on their operations, so it's private employment friendly. Although that might be true, again few things:

1. There is no way to keep this within the realm of encouragement and stop it from taking on bubble proportions. Alan Greenspan surely was trying to 'encourage' home ownership not quite create a housing bubble! And we know what happened. Folks wax eloquent about production of Google and the likes on the the free flow of money into IPO and secondary stockmarkets, encouraged by tax policy. But they look the other way on the fact that silicon valley is more a symbol of Capital waste than successful ventures, financed as they are on the mere names of buzzwords and the PhD programs of the venture founders. Which invokes my next observation that:
2. There is not even a shortage of investment or capital market funds to even theoretically merit a babbycuddle on Capital Gains Tax. If the artificial make available funds for capital formation or consumption be held as prudent and sensible, then there is no case for opposing Fed directed ZIRP, and Keynesian spending, yet we know how harmful these can be to private savers and to the stability of the currency.
3. Artificially low Capital Gains tax can cut both ways. It makes it easy to jump into a stock, but it also makes it easy to dump it at the smallest of rumor or speculation, destroying 'shareholder value'.

  

All things considered, it is the opinion of this writer that Capital Gains taxes be given some sort of parity with income from hard work. That is, Capital Gains be added to one's total taxable income, with a portion of it , increasing with holding time, as tax free - as some sort of inflation indexation of the cost basis. Say, e.g., for every 1 year of holding time, 10% of the Capital Gain realized be tax exempt, and the rest simply added to the total taxable income of the person, participating in the same tax rate slabs as all other types of income.

Furthermore, trading of financial assets should also haul some transaction tax say @ 0.5% per transaction, like the Sales Tax on change of hands with physical goods.

Needless to add, rationalization of taxes on income from financial markets will contribute to the competing objectives of deficit reduction, reducing tax rates generically, and funding the Jobs Bill.