Suppose that I would have invested $X in the absence of taxes, but I am now subject to a 50% tax rate. For simplicity assume the risk-free rate is 0 (it doesn’t change the calculation).
Instead of investing $X, I will now invest $2X (potentially taking out a 0-interest loan to do it).
If $X would have earned $Y of investment income/loss, then my $2X investment will earn $2Y of income/loss. I pay 50% of this as taxes. So my take-home income is $Y—exactly the same as if there had been no taxes.
This does discourage me from spending time finding good investments if they aren’t scalable—but only in exactly the same way as it discourages all other labor, so in this case it’s fixing a bug in the current tax code. In fact, I claim that any non-scalable investment was actually totally reasonable to tax, and we’re discouraging exactly the right set of stuff.
Is there enough money in the world for all investments to lever up 100%? There’s certainly not enough that the borrowing costs would be trivial, if debt demand were suddenly so high.
Also, 100% leverage doubles the risk for the same return (by hypothesis) which probably needs some more support before it’s clear that that is socially better compared to status quo. Note that many investment strategies get totally wiped out (due to gambler’s ruin) if risk gets too high for the same return.
A better model is that investment capital seeks the best risk adjusted return. Right now there’s a balance between opportunities in debt, equities, real assets, etc. If you increase taxes and therefore decrease return on equities, enough capital will move out to other asset classes until the risk adjusted returns are roughly equal.
Maybe that new equilibrium is better or maybe it’s worse, but denying that it will change I think makes your analysis hard to accept.
Is there enough money in the world for all investments to lever up 100%?
Yes :) But in some sense this is just equivalent to the worry that interest rates will go up.
There’s certainly not enough that the borrowing costs would be trivial, if debt demand were suddenly so high.
It’s possible that short-term interest rates would go up. This is basically the government financing large investments to match private returns, and the extra borrowing can drive up the interest rate.
Also, 100% leverage doubles the risk for the same return (by hypothesis) which probably needs some more support before it’s clear that that is socially better compared to status quo.
This proposal introduces some additional variance in tax revenue (it doesn’t increase variance for the taxpayer, since they are just giving a slice of the profits or losses to the government while keeping the same $---and the same variance—for themselves). I agree it’s complicated whether you are actually coming out ahead though I think you probably are by a fairly large margin, similar to a sovereign wealth fund. Certainly if people think that the excess returns to capital are an undesirable source of inequality, they should definitely want to do something like this.
A better model is that investment capital seeks the best risk adjusted return. Right now there’s a balance between opportunities in debt, equities, real assets, etc. If you increase taxes and therefore decrease return on equities, enough capital will move out to other asset classes until the risk adjusted returns are roughly equal.
Maybe that new equilibrium is better or maybe it’s worse, but denying that it will change I think makes your analysis hard to accept.
I think the thing that needs analysis is what this does to the government’s balance sheet, and especially the impact of the extra variance in tax revenues.
(The returns to equities will tend to fall because the government is effectively running a giant sovereign wealth fund, matching all investment from the private sector. They won’t fall because of taxes reducing the returns though, at least not if investors are profit-maximizing.)
I guess I’m just dense here, but I still don’t see how it can be that the risk adjusted return on capital is unaffected by taxes. Borrowing money (i.e. leverage) adds risk so that can’t be it (or there’s an additional mechanism that comes into play). Later you say that the government is a partner but they aren’t reducing your risk, they’re just taking half your profits.
Probably not worth the back-and-forth more here but to me the “taxes don’t affect returns” position is just obviously wrong and nothing you’ve said shows a mechanism that would change that.
Let’s say the risk-free rate is 0 and the tax rate is 50%. Then 2x leverage doubles your profit and doubles your losses—that’s the sense in which it increases risk. But then taxes cut your profit and losses by the same 50%.
So consider an investment that doubles your money with probability 60%. Without taxes you wanted to invest $X, and have a 60% of making $X and a 40% chance of losing $X. But with a 50% tax rate, you want to invest $2X. Then you have a 60% chance of making $2X, paying half in taxes, and ending up with $X in profit; and a 40% chance of losing $2X, getting half back as a tax rebate, and ending up with $X in losses. So the outcome is identical to the pre-tax world.
Getting back the money immediately, without FUD about whether you’ll ever be able to use the tax rebate, is pretty important to meaningfully reducing your risk. (You also are going to need that rebate in order to pay off the margin loan, and someone is willing to lend it to you precisely because they know that you can use your tax rebate to make them whole if you get wiped out. One reason this may not work in practice is that the person making the margin loan may be concerned about seniority of their debt if they can’t directly claim your tax rebate in the same way a margin lender would traditionally liquidate your assets.)
If the risk-free rate is not zero then the exact same analysis applies---2x leverage multiplies (your return—the risk free rate) by 2, and then a 50% tax rate reduces (your return—the risk free rate) by 2.
tl;dr; - we (the economy) currently spend too much labor finding marginal investments because that activity is under-taxed. So less investment would be a good thing.
If I have $100,000 in a savings account, someone could spend X hours to invest that money and over a time t double it to $200,000. That value needs to be divided among:
The government (as taxes),
The X hours of work,
The time t of capital use (which also compensates capital for the risk).
The key fulcrum there is $/X—people won’t spend time finding good investments unless they can make enough $ from that to justify not spending the time doing something else.
If it is easy for people to find things to invest in, they will pay more for capital, and returns for t go up. If it is hard (or there is just too much capital) then returns to t go down.
When taxes go up, that reduces the pool available for X (and paying for t). Which would make marginal investments not happen. Which reduces the demand for capital, so first the return on capital will reduce to zero profit (after adjusting for inflation and risk), and then marginal investments won’t be discovered and funded.
Now, note how this interacts with the proposed policy:
Taxes on capital over time are set at 0. We are only taxing the excess returns above “safe” and refunding for losses as we go, so there is no tax collected on the portion of the profit allocated to capital
The tax rate on the portion allocated to labor is set equal to that on other labor. Currently, spending time to find investment opportunities has a lower tax rate than spending time working as a dental hygienist. That is a distortion that is causing people to spend more time setting up tax shelters / analyzing stocks instead of doing other things that would also be productive. Plus doing things like shifting payments to executives and investment managers to the form of capital gains as a pure tax dodge.
What about the argument that increased capital gains tax reduces investment?
I don’t think that’s the case for this proposal.
Suppose that I would have invested $X in the absence of taxes, but I am now subject to a 50% tax rate. For simplicity assume the risk-free rate is 0 (it doesn’t change the calculation).
Instead of investing $X, I will now invest $2X (potentially taking out a 0-interest loan to do it).
If $X would have earned $Y of investment income/loss, then my $2X investment will earn $2Y of income/loss. I pay 50% of this as taxes. So my take-home income is $Y—exactly the same as if there had been no taxes.
This does discourage me from spending time finding good investments if they aren’t scalable—but only in exactly the same way as it discourages all other labor, so in this case it’s fixing a bug in the current tax code. In fact, I claim that any non-scalable investment was actually totally reasonable to tax, and we’re discouraging exactly the right set of stuff.
Is there enough money in the world for all investments to lever up 100%? There’s certainly not enough that the borrowing costs would be trivial, if debt demand were suddenly so high.
Also, 100% leverage doubles the risk for the same return (by hypothesis) which probably needs some more support before it’s clear that that is socially better compared to status quo. Note that many investment strategies get totally wiped out (due to gambler’s ruin) if risk gets too high for the same return.
A better model is that investment capital seeks the best risk adjusted return. Right now there’s a balance between opportunities in debt, equities, real assets, etc. If you increase taxes and therefore decrease return on equities, enough capital will move out to other asset classes until the risk adjusted returns are roughly equal.
Maybe that new equilibrium is better or maybe it’s worse, but denying that it will change I think makes your analysis hard to accept.
Yes :) But in some sense this is just equivalent to the worry that interest rates will go up.
It’s possible that short-term interest rates would go up. This is basically the government financing large investments to match private returns, and the extra borrowing can drive up the interest rate.
This proposal introduces some additional variance in tax revenue (it doesn’t increase variance for the taxpayer, since they are just giving a slice of the profits or losses to the government while keeping the same $---and the same variance—for themselves). I agree it’s complicated whether you are actually coming out ahead though I think you probably are by a fairly large margin, similar to a sovereign wealth fund. Certainly if people think that the excess returns to capital are an undesirable source of inequality, they should definitely want to do something like this.
I think the thing that needs analysis is what this does to the government’s balance sheet, and especially the impact of the extra variance in tax revenues.
(The returns to equities will tend to fall because the government is effectively running a giant sovereign wealth fund, matching all investment from the private sector. They won’t fall because of taxes reducing the returns though, at least not if investors are profit-maximizing.)
Investors are not profit-maximizing. Investors are (arguably) risk-adjusted profit-maximizing.
Sure, sorry for the shorthand.
I guess I’m just dense here, but I still don’t see how it can be that the risk adjusted return on capital is unaffected by taxes. Borrowing money (i.e. leverage) adds risk so that can’t be it (or there’s an additional mechanism that comes into play). Later you say that the government is a partner but they aren’t reducing your risk, they’re just taking half your profits.
Probably not worth the back-and-forth more here but to me the “taxes don’t affect returns” position is just obviously wrong and nothing you’ve said shows a mechanism that would change that.
Let’s say the risk-free rate is 0 and the tax rate is 50%. Then 2x leverage doubles your profit and doubles your losses—that’s the sense in which it increases risk. But then taxes cut your profit and losses by the same 50%.
So consider an investment that doubles your money with probability 60%. Without taxes you wanted to invest $X, and have a 60% of making $X and a 40% chance of losing $X. But with a 50% tax rate, you want to invest $2X. Then you have a 60% chance of making $2X, paying half in taxes, and ending up with $X in profit; and a 40% chance of losing $2X, getting half back as a tax rebate, and ending up with $X in losses. So the outcome is identical to the pre-tax world.
Getting back the money immediately, without FUD about whether you’ll ever be able to use the tax rebate, is pretty important to meaningfully reducing your risk. (You also are going to need that rebate in order to pay off the margin loan, and someone is willing to lend it to you precisely because they know that you can use your tax rebate to make them whole if you get wiped out. One reason this may not work in practice is that the person making the margin loan may be concerned about seniority of their debt if they can’t directly claim your tax rebate in the same way a margin lender would traditionally liquidate your assets.)
If the risk-free rate is not zero then the exact same analysis applies---2x leverage multiplies (your return—the risk free rate) by 2, and then a 50% tax rate reduces (your return—the risk free rate) by 2.
tl;dr; - we (the economy) currently spend too much labor finding marginal investments because that activity is under-taxed. So less investment would be a good thing.
If I have $100,000 in a savings account, someone could spend X hours to invest that money and over a time t double it to $200,000. That value needs to be divided among:
The government (as taxes),
The X hours of work,
The time t of capital use (which also compensates capital for the risk).
The key fulcrum there is $/X—people won’t spend time finding good investments unless they can make enough $ from that to justify not spending the time doing something else.
If it is easy for people to find things to invest in, they will pay more for capital, and returns for t go up. If it is hard (or there is just too much capital) then returns to t go down.
When taxes go up, that reduces the pool available for X (and paying for t). Which would make marginal investments not happen. Which reduces the demand for capital, so first the return on capital will reduce to zero profit (after adjusting for inflation and risk), and then marginal investments won’t be discovered and funded.
Now, note how this interacts with the proposed policy:
Taxes on capital over time are set at 0. We are only taxing the excess returns above “safe” and refunding for losses as we go, so there is no tax collected on the portion of the profit allocated to capital
The tax rate on the portion allocated to labor is set equal to that on other labor. Currently, spending time to find investment opportunities has a lower tax rate than spending time working as a dental hygienist. That is a distortion that is causing people to spend more time setting up tax shelters / analyzing stocks instead of doing other things that would also be productive. Plus doing things like shifting payments to executives and investment managers to the form of capital gains as a pure tax dodge.