Thursday, December 2, 2010

Rethinking the Function of Taxation

I've come to the realization that taxation determines whether an economy is capitalist or financialist.  Let me explain what I mean and the implications of viewing the world this way.

In a prior post, I stated:

The focus of this "checkpoint" post is tax policy, which many claim redistributes wealth. This is incorrect. Tax policy, against the broader background established by monetary, fiscal and industrial policies, does not so much affect one's wealth as how one's wealth is distributed among wages, entrepeneurship and rent-seeking.
I've emphasized "wages, enterpeneurship and rent-seeking" because implicit in this statement is the classical economic triumverate of labor, capital and rents, which I think (mostly) accurately describe what one would find in a capitalist economy.  There is a trick here, however, and that is the composition of "rents." 

Classical economics was developed at a time when both land rents and pure financial speculation existed.  Since both rents and the gains from speculation are "money from nothing," I have to believe that speculative gains (which I will call "winnings" from here on at)  were folded into the conception of rents as used by classical economists.  I'm sure that I could quickly confirm my intuition, but it is a secondary issue.  I understand from, oddly enough, an reviewer, that Adam Smith viewed speculators as a particular problem and even made recommendations similar to mine that money should not be lent to them for the purposes of speculation (I'll have to read the pages the reviewer identifies from Wealth of Nations). 

It may well be that classical economics was developed to paper over the dangers of speculative bubbles due to debt-financed asset speculation, which Smith (apparently) clearly identified and discussed in 1776.  Perhaps one way to think about things is that Smith viewed the economy was in terms of labor, capital, rents and winnings, and the classical economists came along and "disappeared" winnings into rents, just as neoclassical economists came along and disappeared rents (including winnings) into capital, just as neoliberal economists through direct financialization of the real economy have disappeared labor into capital, thus abstracting the real economy away entirely.

Regardless whether this theory actually pans out, I feel compelled to consider the real economy in terms of four factors, not three: labor, capital, rents and winnings.

Our current tax system is heavily skewed in favor of rents and winnings and against labor and capital.  Although speculation in the secondary markets is not considered an investment in productive capital for GDP purposes, the tax code treats winnings from longer-term speculative trades as "capital gains."  Similarly, our tax code encourages the destruction of domestic capital and investing in foreign capital by allowing domestic corporations to shield profits made and sold entirely offshore from taxation.  The destruction of domestic capital is commonly known as offshoring jobs because that is the immediate effect on workers (and it plays well in the news), but I think the destruction of capital is the real harm because productive capacity that potentially spans decades is lost.

The current tax system was put in place piece by piece since the days of Ronald Reagan (with some foundational acts by Nixon and Carter).  Another important change was the shift in 1975 to targeting monetary aggregates, which is best viewed as form of inflation targeting.  At the time, stagflation had set in, and monetarists like Milton Friedmand and Paul Volker were complaining that the Fed only focused on managing interest rates and not on the true cause of inflation, i.e., an increasing money supply (specifically, I believe, M0 and M1).  If we apply the key insight of Prospect Theory, which is that loss aversion dominates economic decision-making, and it is easy to see how inflation-targeting results in a strong (if not manic) desire by those who have accumulated wealth to put there money into something that GUARANTEES a return greater than that of constantly compounding rates of inflation. 

Did you catch that?  Inflation-targeting creates a strong demand for "investments" that perpetually and exponetially grow faster than inflation.  (FYI - to make my life easier, I'm going to assign the acronym "PEG" concept of perpetual exponetial growth.)  The result has been a categorical shift away from capitalism and towards financialism as the tax system was skewed to clear the way to meet the demand for PEG investments. 

This suggests that to shift back to capitalism from financialism requires (1) removing the artificial demand for PEG returns on existing wealth caused by inflation targeting  and (2) adjusting tax policy to encourage investment in capital and discouraging speculation.

The first point deals more with monetary policy, which I have not thought through yet within the context of financialism and will save for another time.

Regarding the second point, it makes some sense to start with Henry George.  Henry George proposed his Single Tax as a way of preventing land speculation and doing away with land rents in one fell swoop.  The problem with attempting to apply George's solution today is that, with financialization, pretty much all asset classes have become prone to speculation, relegating land speculation to a bit player.  Indeed, when you consider that the housing bubble was driven by speculation in the derivatives market, we've reached a point where the real economy dog is being wagged by the financialist tail.

Given the ability of financial speculators to innovate around laws and regulations (i.e., cheat), I think it makes sense to apply different tax rates based on the type of income (returns on capital, wages from labor, rents and winnings), with capital income (including dividends) being taxed the least (perhaps even not at all), wage income being taxed modestly more (and most likely less than they are today), rents being taxed moderately more, and winnings being taxed out the wazoo.   

Goodbye debt-financed asset speculation.  Goodbye destruction of domestic capital and job offshoring.  Goodbye average people complaining about income taxes (and thus being coopted to vote against their own best interests).  Goodbye banksters. 

Hello domestic capital investment.  Hello full employment.  Hello American capitalism.

I definintely need to put more thought into this, but I wanted to put a stake in the ground.  I suspect that CAPM itself provides the basis for constructing tax and monetary policy so as to render CAPM inoperative and unattractive.  One key thing to do is use tax and monetary policy to twist the dials of the Miller and Modigliani equations to make it clear that actual investment provides a far better return than speculation.