Part 4: The Importance of Investment

If you haven't read part 1 (here),  part 2 (here) and part 3 (here), please do. I've made updates to all 3 in order to add clarity to some of the terminology so you may want to take the time to reread them.

Terminology:

Aggregate demand -- The total amount of goods and services demanded in the economy at a given overall price level and in a given time period.

Supply-side (economics) -- An idea that says economic growth is most effectively created by lowering barriers for people to produce (supply) goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing regulation. Supply-side advocates favor income tax reduction because they believe it increases private investment in corporations, facilities, and equipment.

Let's back up for a moment and review what I'm trying to accomplish with this 4-part series. First off, let me explain my underlying goal, in case it's not obvious:

Why do we place more emphasis on capital investment as opposed to income from wages?

The emphasis I'm referring to is the fact that we apply preferential tax treatment to certain forms of capital income (e.g., LT capital gains and qualified dividends). The reason we do this is because certain people believe that the incentive this behavior provides will have the greatest positive impact on GDP, which is among the important measures of the economy's current health. In other words, they're making an investment in our economy. That's the hypothesis, at least.

Now, one of the challenges we have as Americans is the emphasis we unknowingly place on labels. Many Americans associate the label of "investment" with the privileged or something you've earned, which means it has a positive connotation. "Wage income" is considered something you have to do in order to survive so it has a much less favorable connotation associated with it. Unfortunately, I believe this perception influences the average American, who typically puts less effort into understanding the fundamentals that drive our economy.

So, when it comes to the subject of capital income, I believe there is no one term that's more misused than "investment." Again, what we care about with investment is whether it's being used to increase the number of people employed (i.e., job creation) or productivity growth because those are the only two sources of real GDP growth. The abuse of the term investment has to do with the issue that there's an assumption or (false) belief that all capital gains and income from interest and dividends are somehow directly added to GDP. They're not! Allow me to explain.

First, let's start by separating investments into two categories: Inside vs Outside. Inside investors operate businesses and when they make capital investments, the effect has an immediate and positive impact on GDP. Outside investors are the rest of us who provide capital for inside investors. When an outside investor makes an investment nothing happens *until* the inside investor does something with the money. Also, the profits paid to an outside investor do not add to GDP because they're merely a transfer from the inside investor. In addition, most investment activity occurs by outside investors and the only outside investment that is directly added to GDP is venture capital (VC) funding.

For example, think of initial public offerings (IPOs). IPOs are used by companies to raise capital for expansion and to monetize the investment of early investors (usually a VC firm). If the capital raised from an IPO is used for expansion, then the company creates more jobs or produces more/better products. In other words, that portion of the IPO proceeds does, in fact, contribute to real GDP growth. However, Facebook's IPO is a good example of raising capital primarily to monetize the investment of early investors because Facebook already had plenty of cash they could use for expansion. So, there's a good argument to make that not even all IPOs, like Facebook's, are directly added to GDP. Either way, capital gains from VC investment actually make up a relatively small percentage of total realizations (or profits).

Now, without a doubt, these other forms of capital investment certainly have secondary or tertiary effects on GDP. However, income from wages has an immediate impact on our economy because it drives consumption which in turn drives aggregate demand.

So, if all of these other so-called investments like stock and bond purchases aren't investments, then what are they? Well, they're nothing more than asset exchanges. You're not investing in our economy when you buy a stock because the real investment most likely occurred at IPO decades ago. All you've done is transfer the asset from one person to another. We call them "investments" but the reality is that they do less to contribute to grow GDP than what a reasonable increase in a worker's salary would do.

You still have your doubts? Maybe this will help:

- Median household (wage) income is down 7.3% since the start of the recession*
- The Dow and S&P index, which are a reflection of capital investment, have more than doubled since their recession lows

The result is a current output gap, the difference between real GDP and potential GDP, of ~$885B.**

Now, I do realize there are other factors that come into play here (e.g., the Feds involvement with money supply) so the above correlation isn't perfect, by any means. There are leading and lagging indicators that enable us to gauge the state of our economy and the two above fall into one of those two categories. However, the point is that we've had an output gap that's been sitting around $1T for 4 years now and we don't typically see (or have ever seen) a stock market that has been completely out of sync with our economy for such a long period of time. This result leads me to the conclusion that throwing a bunch of money at the supply-side, while allowing the demand-side to remain stagnant, isn't boosting our economy one single bit.

I'm not saying the preferential treatment applied toward capital income is bogus. I'm just saying that I believe it's misguided and doesn't address the fundamental issue. Without a doubt, when someone makes an investment that's directly responsible for the expansion of a business then it should get preferential tax treatment. However, that activity is a small fraction of what gets preferential treatment today.

Lastly, if we believe the idea that certain types of income should be given preferential tax treatment based on their ability to directly impact GDP, which again is a primary measure of our economy, then maybe we should consider favoring wage income over most types of capital income. At a minimum, any so-called investment that qualifies as an asset exchange should be taxed no differently than income from wages.

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* -- http://www.sentierresearch.com/reports/Sentier_Household_Income_Trends_Report_February2013_03_25_13.pdf

** -- http://stateofworkingamerica.org/charts/output-gap-real-gdp-compared-to-potential-gdp-2000-11/

Interesting Observations on ATRA

ATRA (American Taxpayer Relief Act) is the new tax policy for 2013 as a result of the Fiscal Cliff negotiations. Overall, if our primary goal was deficit reduction then the new law is a joke. I don't know why I'm so disappointed since it was stupid of me to think that we'd actually come up with something somewhat reasonable. Here's the ridiculous progression from where we started to where we ended up (realizing that we punted the spending cut debate for another two months):

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/02/the-fiscal-cliff-negotiations-in-one-chart/

I find it comical that we ended with less revenue from tax increases in the final deal than we did in either proposal from Boehner. Although, I'm not sure how definitive Boehner's tax increases really were. I get a sense the estimates for Boehner's two proposals shown in the link above were highly optimistic.

Anyway, here are the "interesting" observations so far:

1. The average American making between $200k - $500k made out very well relative to everyone else. Their change in after-tax income -- that's "cash income"* as defined by the Tax Policy Center (TPC) -- was the 2nd lowest (-1.3%) behind those making between $10k - $20k (-1.0%). In other words, the average middle-class (and upper-middle class) American, which I'll loosely define as someone making between $50k - $200k**, will see their after-tax income decrease, as a percentage of their cash income, more than the average American who makes between $200k - $500k.

Here's the distribution table:

http://www.taxpolicycenter.org/numbers/displayatab.cfm?Docid=3755&DocTypeID=1

Relatively speaking, this sounds like a lousy deal for the middle and upper-middle classes who saw their after-tax income decrease between 1.5% - 1.7%. Of course, let's not freak out too much since we're only talking about .4% here.

2. Personal Exemption Phaseout (PEP) and Pease (the limitation on itemized deductions named after the congressman who introduced it) will account for the second-largest increase in potential revenue yet they were never really discussed in the press as being a factor.

Now, some people are complaining about how much PEP and Pease will affect taxpayers who make >$250k/$300k (single/married). From what I'm reading so far, it's mostly GOP/conservatives, some religious organizations and nonprofits focused on charitable giving, and some home builder associations. It should give you a sense of how difficult it will be to truly simplify the tax code and eliminate most of these ridiculous loopholes and subsidies.*** It's like the saying goes, "It's a great idea until it impacts you."

The fundamental problem with PEP and Pease is that they add to the complexity of our tax code rather than reduce it. For example, I'm sure most people who are reading this are saying, "WTH is PEP and Pease???"

I will add other interesting observations to this list as I see them in the coming days…

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* -- Cash income is different than Adjusted Gross Income (AGI), which is what everyone sees on their IRS form. Cash income is used by the TPC because it's a better reflection of the taxpayers' ability to pay tax. See: http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=574.

** -- It's certainly debatable about where the income level starts and ends for what I'm calling "middle" and "upper-middle" classes. Considering those who make $200k puts you in the ~94th percentile, it's probably a stretch to call them upper-middle class. Keep in mind, there really is no official definition though.

*** -- I don't consider charitable giving to be either ridiculous or a subsidy. However, I do have very mixed feelings about religious organizations receiving tax-exempt status. Although, I do think the positives outweigh the negatives.

Part 3: Greater Risk-Greater Reward

If you didn't catch Part 2 then read it here.

Another common claim for lower rates on capital income is the argument that the risk associated with capital income is greater than the risk associated with wage income.

First off, risk is obviously relative to the person experiencing it. I'll use myself as an example because 1) most of my net worth is invested in the stock and bond markets so I obviously care about capital income and 2) my wage income comes from a job that has been and still is in very high demand within this country. Point being: I probably have one of the most risk-free jobs in the nation.

Having said that, I can tell you that I have far greater stress from risk associated with my job (wage income) than I do from my investments (capital income). Here's why:

- If I don't perform technically well at my job then there's a significant risk that I will be let go for performance reasons -- we lose people in similar positions for similar reasons within my company all of the time.

- If I don't "click" with my boss then I run the risk of getting forced out -- I actually had this issue last year.

- If my sales rep and I don't meet our quota, for whatever reason (e.g., my accounts just have a bad year), then I run the risk of being let go for performance reasons. 

- If my company merges with another company, something that happens a lot in my industry, then I run the risk of getting laid off due to a reduction-in-force (RIF).

If I'm let go, forced out, laid off, or whatever, then I have to address how I'm going to get and pay for health insurance for my family and that's highly stressful. Clearly, I could go on and provide more examples of risk through wage income.

Bottom line, the risk I feel based on my dependence on wage income is far greater than the risk I feel based on any potential losses I might experience with my investments. Now, you might say that someone who receives most of their annual earnings from capital will feel differently. Sure, they probably would. Keep in mind, I lost ~40% of my net worth in 2008 so I fully understand the risk and pain of losing money on your investments. However, if you were to ask me, "Where would you apply preferential tax treatment (wage income vs capital income) if the decision had to be based solely on risk?" then I'd say, "wage income."

So, why is their risk more important than my risk? More importantly, why does their risk justify preferential tax treatment and mine doesn't? If your answer is: Because capital is more important to the economy than wages, then hold that thought and wait for my next blog post.

Next up: The Importance of Investment

Part 2: Inflation and the Savings Disincentive

If you didn't catch Part 1 then read it here. I've recently updated it.

Again, let's start with some basic terminology:

Nominal vs Real -- There's a concept in finance theory that says the value of money today will not be equal to the same amount of money in the future due to factors like inflation. The nominal value is the amount unadjusted for inflation while the real value is the amount adjusted for inflation.

Inflation Index -- A tool used to measure the rate on inflation in an economy (e.g., CPI).

One of the common complaints about taxes on capital income is that the profit on a capital gain or the interest income on an investment are decreased due to inflation. As a result, an investor is paying tax on inflation (a.k.a., an "inflation tax"). There can even be situations where inflation grows at a greater rate than the nominal gain or nominal interest on the investment. In this case, the investor will still pay a tax on the capital gain profit (or interest income), when, in fact, the real gain (or real income) was a loss (or negative). This distortion is due to the fact that capital income is not indexed for inflation. This lack of inflation indexing is one of the reasons why people often say "inflation discourages savings and investment." Again, I find this statement a bit disingenuous since it's similar to saying, "Since inflation is going to reduce my after-tax gain or income on my investment, I'd rather make nothing, or even possibly lose money, by not saving and investing at all."

In addition, as Rick Ashburn from Creekside Partners reminds me, there's a paradox regarding saving that is important to understand: What works when examining a single household (think in terms of a single economic agent), doesn't necessarily work for the economy as a whole. The simple example is that any given economic agent can save most of their earnings and retire early. However, that doesn't work for the entire economy due to the need for consumption. So, the "save a lot and retire young" proverb can never be a societal goal. I mention this because the average American tends to think along the lines of what makes sense only from a microeconomic perspective and often overlooks the importance of what makes sense from a macroeconomic perspective.

Now, most features of the federal income tax system for wages are indexed for inflation, which means we can't necessarily say that taxes on wage income suffer from the same issue. However, many states do not index their income tax systems for wages. Therefore, it's important to understand that indexing for inflation is not something we do consistently for all taxes on wage income. Lastly, the lack of indexing can work in our favor too. A good example is a person with a fixed-mortgage payment will see that payment decline as a share of his income as inflation pushes up his wages.

So, does the lack of indexing for inflation justify lower rates for capital income? Of course it doesn't. We shouldn't fix a dynamic issue with a static solution. If we're genuinely interested in addressing the fundamental issue then I believe we should fix the problem by indexing for inflation, not by lowering rates on capital gains and interest to make up for the distortion.

Next up: Greater Risk-Greater Reward

Capital Gains Misinformation

Here's a series on what I believe is a combination of misinformation and deception surrounding the justification for lower rates on capital gains realizations. As I'm sure many of you know, there's a fervent debate about whether capital income should be taxed as ordinary (wage) income, well below ordinary income (as they are today) or possibly not even taxed at all.

I'll start with some basic terminology:

Capital Income -- Income from capital gains, interest and dividends. Capital income is categorized as 'unearned income' (or passive income) by the IRS.

Note: The terms "capital gains" and "capital income" are sometimes used interchangeably when they actually shouldn't be. Often when people say "capital gains," they really mean "capital income." It's probably because capital gains just gets more attention than the other two (interest and dividends). In addition, current policy (2012) states that interest is taxed as ordinary income (i.e., at marginal/statutory rates) while capital gains and dividends are taxed at 15% (or 0% for the bottom two income brackets). To complicate things even further, only long-term capital gains (assets held longer than one year) and qualified dividends (ordinary dividends that meet specific requirements) are taxed at that lower rate. So, not all components of capital income are taxed the same which is why we have to be careful when discussing taxation on capital income.

Wage Income (a.k.a., ordinary income) -- Income from labor and services. Wage income is categorized as 'earned income' (or active income) by the IRS.

There are several reasons often cited by "low rates for capital income" advocates. They are:

1. Double taxation
2. Inflation and the savings disincentive
3. Greater risk-greater reward
4. The importance of investment

I'll tackle each one of these in separate posts. The first post will focus on double taxation.

The topic of double taxation drives me a bit crazy because we know there are plenty of smart people out there who understand this basic concept but they continue to play what I believe are word games with the intent to deceive others. The best answer always resides in the moral philosophy or principle behind the purpose. So, as my good friend, Rick at Creekside Partners, best described to me regarding taxes:

"Taxes are transfers of money from one party to another, for value added/received. Our economy (and system of governance) is based in part on the presumption that, when money changes hands, it is for a reason: Value added, and value received."

The example that everyone uses -- i.e., dividends distributed to shareholders have already been taxed at the corporate level -- involves two distinctly different entities. This is not double taxation because taxes should occur at every point of transfer.

Now, even if you refuse to subscribe to the above philosophy and still insist that double taxation exists for capital income, then you have to make the same claim for wage income. Why? Because your after-tax dollars from wage income are also taxed again when you:

buy general commodities (commonly known as a "sales tax")
buy gasoline (average of 60 cents per gallon in the U.S.)
buy alcohol or tobacco (they call these "sin taxes")
register your car (they call these "fees")
drive on a toll road/bridge (they call these "tolls")
try to build or remodel something on your own property (they call these "permits")
try to start a business (they call this a "license")
I could go on...

Lastly, there are actually situations where the gov't takes a double hit on their end -- e.g., employer-provided healthcare premiums are exempt and they're also deducted as a business expense. This costs the gov't well over $100B/year.

When you really think about it, this "double taxation" claim is rather silly. But I'll admit the first time I heard it (without researching it), I also fell for it. Unfortunately, in the end, many people will believe only what they want to believe. The truth is less of a priority with them.

Why am I doing this blog? Because the lack of knowledge on public and private finance among the average American is astounding to me. More importantly, I'm disappointed with their general lack of desire to better understand the subject given how critical it is to our success as a country. As Bankers Anonymous states, "I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society." Trust me, I'm still learning too. This is an opportunity for me to teach and discuss/debate what I know and to learn much more myself.

Next up: Inflation and the savings disincentive