Lower capital gains taxes fueled a Wall Street bubble.

While recently engaged in a dialogue with an individual who was upset with the greed on Wall Street and wanted to increase corporate taxes, I realized that he was unable to understand the difference between corporate taxes and capital gains taxes, and that neither political party or the media have been very helpful in educating American citizens about the difference—and the difference is huge.

Capitals gains taxes are taxes on profits that investors make on investments in corporate stocks.

Capital gains are also profits on other types of asset appreciation, including land, homes, and other non-paper investments. However, with the large increase in managed portfolios for retirement funds, capital gains on paper investments like corporate stocks have played a significant role in reshaping the US economy. No longer are just a few venture capitalists hoping to strike it rich on Wall Street, but tax deferred 401k and 403b retirement accounts have turned most government and corporate employees, both Democrat and Republican, into investors in corporate stocks. Wall Street has become a Main Street idea. Republicans like Mitt Romney, who worked at Bain Capital, argue that these taxes should be kept low so that individuals will invest their money in corporations. Reductions in capital gains taxes were part of the “Reaganomics” strategy that brought in more investment capital and led to the rebirth of the American economy and jobs in the 1980s that is worthy of being called “miraculous.” Their success has caused many people to advocate low or no taxes on capital gains as a way to create jobs, and this is a priority on the Republican Party Platform.

The Wall Street boom that accompanied the increased investments in the 1980s led to many opportunities, challenges, and changes on Wall Street. Large concentrations of money in one place led to many temptations, wider acceptance of greed, higher payouts, and bought-off regulators in the SEC. Banks wanted to begin investing, using money from FDIC guaranteed depositors to speculate on the market. Both Republicans and Democrats received increased contributions from Wall Street and banking lobbyists. There were inadequate checks and balances in the system to prevent this behavior and politicians in both parties turned a blind eye, letting the “good times roll.”

But, like in the 1920s these good times carried seeds of the present economic crisis:

1. Politicians caught up in the euphoria repealed the Glass-Steagall Act, which had prevented banks from mixing banking with investment and speculation. This legislation was bipartisan, initiated by a Republican Congress and signed  by a Democratic President. It helped generate a wave corporate scandals and reinforced the culture of greed, documented in the book Corporate Scandals: The Many Faces of Greed.
2. Low capital gains taxes, combined with high taxes on corporations, led to a wave of mergers and acquisitions that bought out and dissembled family-owned and small businesses, replacing them with large chain stores, and banks “too big to fail.” This is because there was a large investment profit motive but weak incentives for corporations to show a profit. This had the effect of reducing the number of middle-class merchants and widening the gap between upper and lower classes. Low capital gains taxes would not have had this effect if there were no corporate taxes.
3. Globalization of markets steered this new found investment capital overseas, because investment capital seeks the highest return. Highly taxed US corporations (the most highly taxed in the world at 39 percent) were far less lucrative. Therefore decreased capital gains taxes no longer contribute as much to investing in U.S. corporations that create jobs for middle-class Americans, because those corporate taxes and regulations increasingly pressure firms to move out of the United States where investments will be better rewarded.
4. Laws passed by Congress that subsidized or guaranteed home loans added to the risk and greed in the system by tempting mortgage sellers and real estate developers to build and sell houses that were based on an artificial market and buyers who were unable to repay the loans–the taxpayer would absorb the losses.
5. This led to a predictable, and predicted, bubble and collapse that caused massive unemployment, less tax revenue, and more welfare burden for the government. Beginning a downward economic spiral.

This present downward economic spiral will not be halted by either an increase or decrease in capital gains taxes.

Corporate taxes are taxes on corporate profits, and high corporation taxes decrease the incentive for a corporation to produce a profit.

At 39 percent, the taxes on U.S. corporations are the highest in the world. Last year, Japan, the only country in the world with higher corporate taxes, reduced them to stimulate production. So-called “socialist” nations like China, Russia or Denmark tax their corporations at 20%, 20% and 25% respectively making the U.S. more socialist in actual practice. The bitter experience of communism has taught policy makers in these countries that public ownership of corporations, or high taxation of corporations–which effectively is the same thing–decreases production because people are less motivated to work if they cannot keep a good portion of the fruits of their labor.

What happens to corporations when taxes are increased?

1. They seek not to show a profit, but rather to spend money that would otherwise go to the government. This is why over 60% of all U.S. corporations and 35% of large corporations paid no corporate taxes in recent years.
2. How do corporations spend would-be profits instead of paying taxes?
   1. They pay bonuses to employees at the end of the year.
   2. They do extra advertising, some of it by throwing lavish parties.
   3. Large corporations pay lawyers to find or lobby for ways to avoid paying taxes (loopholes).
3. What do corporations fail to do when taxes are high?
   1. They fail to invest in buildings and equipment, because that is figured as increased net worth for tax purposes.
   2. They fail to produce large inventories as they are considered increased net worth.
   3. They fail to reinvest profits in the company causing it to expand and create jobs, because that would be taxed.
4. Corporations are highly motivated to reorganize and incorporate in locations where tax rates are lower.

In short, taxing corporations makes no economic sense because such taxes inhibit investment in domestic production and encourage moving production to more favorable locations. If there are taxes on corporations, they should in every case be at a lower rate than capital gains taxes because today corporate profits are more likely to be invested in domestic jobs and production of goods than is Wall Street capital.

As other Countries Reduce corporate taxes, the US is falling further behind.

The net result of recent US tax policy is that corporate investment is increasingly made through Wall Street firms, engaged in capital consolidation rather than by actual producers. This has displaced privately owned companies and small businesses and stimulated retail chain stores and the movement of production offshore. The result is an unsustainable economy because the system relies on larger numbers of consumers who have increasingly fewer jobs and lower wages. It makes it harder for the government to collect taxes when the economy is shrinking.

Today this pressure on state revenues has caused government bureaucrats and populists to demand to “increase taxes on the rich.” Their rhetoric does not separate taxes on rich people from taxes on corporations. We can understand people employed by government demanding these taxes simply because their own fear of job insecurity will likely take a priority over the well-being of the entire economy. On the other hand, the populist demand to increase taxes on corporations is likely a result of a sense of injustice combined with blindness to the extremely important distinction between capital gains taxes and taxes on corporations themselves. As a result, populists might advocate an increased tax on corporations out of ignorance of the means to achieve their own ends.

Taxes on Labor vs. Taxes on Passive Income: A Moral Argument

It is well known that people are more likely to work hard, or even work at all, if they can keep the fruits of their own labor. And, when people live off of the fruits of another person’s labor it is considered slavery or serfdom. An income tax on wages is a tax on one’s own labor. An income tax on capital gains, on the other hand, is a tax on gains received as a result of another person’s labor. This means that a system of state revenue in which income taxes on passive gains are lower than taxes on labor is a system that promotes a form of economic slavery over economic freedom.

Taxes in an Era of Globalization

Since we now live in a global economy, it is naive for a country to create tax policies without looking around the world and examining the tax policies of the countries that are more competitive. Countries that are largely self-contained (19th century U.S.) or homogenous (modern Denmark) can create very different tax structures than large economies competing in a global market where capital is free to flow to the places that offer business climates that favor cost and the stability that can enable long-term planning. Neither the Republican nor Democratic platforms reflect these real-world economic factors, but rather focus on the short-term financial interests of the largest campaign contributors. Thus, on the Republican side there is a demand to decrease capital gains taxes, which can be viewed as immoral when it is lower than taxes on wages, and will in any case be unlikely to stimulate much job growth in the United States in our now global economy. On the Democratic side the observed wider income disparities creates a desire to resolve economic injustice and is fueling naive, punitive, and confused tax strategies that will continue to provide an inhospitable climate for economic production and the middle-class jobs associated with production.

With this analysis, we can conclude that neither President Obama nor Gov. Romney are offering clearly viable strategies to create new jobs or fix the ailing economy which both parties have overloaded with debt. Rather we can conclude a viable solution should include these three principles:

1. Income tax rates on capital gains should be higher than the rates on wage labor.
2. Tax rates on capital gains should be higher than corporate taxes.
3. To prevent middle class job drain, corporate taxes should equal or be lower than in other countries and not subject to unpredictable legislation that make planning impossible.

In my book, Life, Liberty, and the Pursuit of Happiness, Version 4.0., I refer to many other changes that can lead to a less corrupt system and a more prosperous and just economy. These include more financial checks and balances, use of courts rather than ineffective and bloated regulatory agencies, and transfer of all income tax authority and social welfare programs to the state level. For purposes of this article, I have pointed out three areas where changes could be more easily made and promoted by a presidential candidate and political parties that would lead to an improved economy and job growth, as long as the debt burden doesn’t lead to a total system collapse.