Freeman

ARTICLE

Eating the Seed Corn

Two Major Confiscatory Policies Discourage Investment

AUGUST 01, 1994 by RAPHAEL G. KAZMANN

Filed Under : Inflation

Mr. Kazmann lives in Baton Rouge, Louisiana.

One of the most telling and widely used arguments made by politicians seeking office is that, if elected, their policy will create jobs. The implication is that governmental actions can create jobs in the private tax-paying sector, not tax-eating jobs in the public sector.

Bitter experience has taught us that production must come before consumption—you can’t consume something that has not been produced. Equally painful experience has shown us that nothing can be produced without the expenditure of capital. To produce something new, or to increase the production of a commodity already on the market, you must invest capital. That is, you must have enough saved out of current consumption to support you while you build the new facility and enough to support the employees while the commodity goes to the market and is sold in sufficient quantities to make the enterprise viable.

This is the situation that faces the farmer as he puts aside edible seed corn for use during the next year. It is the situation that faces the miner, as he explores for economic quantities of metallic ore, of the wildcatter, looking for natural gas, and the writer of software as he works on a new, improved computer program. All enterprises require the investment of capital. Without capital investment there can be no new jobs, and even jobs in existing enterprises may be lost for want of capital for modernization.

It should be evident that the larger the physical plant and the greater the investment of capital, the greater the potential for production and income of the population. More jobs, from a politician’s viewpoint, mean a greater tax base and a reservoir of potentially larger taxes.

What Actually Happens

Yet despite these truths two major confiscatory policies conspire to consume capital (eat the seed corn) before it can be invested (planted): the inheritance tax and the capital gains tax. After a relatively small exemption of $600,000 for a single person ($1,200,000 for a married couple), the inheritance tax climbs to 28 percent and then to 55 percent. At a time when a modest house in the suburbs sells for from $125,000 to $250,000, a $600,000 exemption protects very little investment capital. And the value of the exemption is eroded every year by the inflation.

Proponents of the inheritance tax argue that the rich will gain a stranglehold on the economy unless part of their capital holdings are taxed away by the federal (and state) government. This is based on the assumption that rich people are organized and wish to dominate the gigantic array of competing interests in the marketplace. Of course, there is no way that this can be done without governmental coercion.

In an economy whose gross domestic product is estimated to be $6 trillion, the whole idea is ludicrous. Moreover, since the economy is not static, unless capital is deployed in accordance with market conditions, it is likely to be lost. Where are such industrial giants as Gulf Oil Company, Pan American Airways, and U.S. Steel—all dominant companies in the U.S. economy in the 1960s? They have either gotten much smaller or have been incorporated into competing firms because they couldn’t meet the test of the market. So the inheritance tax, which tends to cripple the economy by reducing the supply of investment capital, is based more on the politician’s desire for more money to hand out than on a rational examination of the facts.

The second major program to consume capital is found in the “capital gains” tax, which recently was increased from 20 percent to 28 percent. This rate applies to investments that have been held for more than one year. A capital gain earned in less than a year is taxed at the ordinary income tax rates—a maximum of about 40 percent. The value of the capital is not indexed for inflation. So if, during the course of holding a $10,000 investment for a period of three years, an inflation totaling 30 percent occurred, and the investment is sold for $13,000 a paper profit of $3,000 would be noted and of this “profit” $840 would be due in taxes, Actually since the investment did not grow but would actually buy the same basket of goods and services for $ 13,000 that it could have bought originally for $10,000, there was no real growth in the investment and the taxman simply confiscated the investment capital of the owner and the productive potential that had existed.

In effect the government first devalues money by running the printing presses and reduces the value of all bonds and corporate debt, then it confiscates capital because of the change in the dollar value that resulted from running the printing presses! It is a prescription for economic disaster.

But if we set aside the inflation factor, a person cannot readily channel funds from one profitable investment to another, potentially more profitable one without allowing for a 28 percent loss in any capital gain that the first investment had achieved. Suppose you had invested $10,000 and its value after 3 years (ignoring inflation) was $13,000, an average of increase of 10 percent a year. Now suppose that you have found an investment that, potentially, might grow during the next three years by an average rate of 12 percent (it might also be a loser). If you sell your original investment, you will have $12,160 to invest, after taxes. After three more years your investment will be worth $16,538. If you keep your original investment and the average rate of return remains at 10 percent, the value of the untouched investment will be $16,900. So switching your money to a more profitable investment (12 percent rather than i0 percent), which is risky, gives you less capital than if you did not switch. Because of this chilling effect on the movement of capital, rational beings will be reluctant to undertake new ventures—even when an increase in the return might change from an average of 10 percent a year to 12 percent a year.

Taxation and Confiscation

In a dynamic economy, where new ventures are constantly being proposed, the tax on capital gains is an important factor influencing the investment of capital. In any rational system of taxation, an increase in productive capacity (which necessarily involves investment of capital) would be welcomed and all irrelevant issues, like capital gains taxes, would be removed. And since a dynamic economy, which moves capital based on economic considerations alone, will create products and employment more rapidly than one laboring under the handicap of capital confiscation, rational government should be the first to remove the handicap and widen the economic base.

It is of interest to note that President Alberto Fujimori of Peru (an economist by training) has eliminated inheritance taxes and has a established a zero tax on capital gains and dividends. According to James Davidson in the Strategic Investment Bulletin of February 23, 1994, tax collections have doubled as a percentage of GDP as compared to the receipts before Fujimori superseded the parliament.

Our own situation is less optimistic. A dictum of Robert Heinlein, slightly modified, comes to mind: “Anyone who cannot cope with elementary economics and mathematics is not fully human. At best he is a tolerable subhuman who has learned to wear shoes, bathe, and not make messes in the house.” This would seem to describe many elected politicians and government policy advisers, who claim they can create jobs. Economic ignorance is disastrous for the economy and society.

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August 1994

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