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/