Saturday, December 27, 2008

Productive and Unproductive Capital
December 27, 2008

Putting capital at risk for a future return is the heart of Capitalism. But not all capital is productive. Encouraging productive capital and taxing unproductive capital is the difference between a financial recovery and a long Depression.

Let's take two wealthy capitalists. One has $10 million in tax-free municipal bonds which earn about $500,000 (5%) in low-risk, no-tax returns. The second one has $10 million sunk into a small business with a payroll of 25 employees and a brick-and-mortar office-warehouse. This "small business" generates millions in payroll and thus in payroll taxes, pays huge property taxes and sales taxes, and also generates tens of thousands of dollars in local government "junk fees" (business licenses, parking permits, fire inspection fees, etc. etc.)

The municipal bond investor is unaffected by the recession/depression until such time as one of the local governments which issued the bonds he owns goes bankrupt. He pays virtually no business or capital-related taxes.

Now let's consider a third capitalist who has $10 million in boutique hedge funds. Accounting legerdemain enables this capitalist to report much of his hedge-fund generated income as long-term capital gains, thus limiting his Federal taxes to 15%. He pays no business-related or payroll taxes, and doesn't even pay any FICA (Social Security) taxes on his income.

Many will note that the buyer of municipal bonds is providing capital which is spent repairing roads and schools, etc. and thus this money is productively invested. Others will claim the hedge funds might have provided capital to far-flung firms and thus "greased the wheels" of some distant productive enterprise.

Nice, but which capitalist is actually supporting his community with jobs and taxes? Only the small business owner. Those investing in Muni bonds and hedge funds may support their local community via consumption (eating out at restaurants, etc.) or they may not. They may be paying significant property taxes, or they may not.

The hedge fund investor certainly has placed his capital at risk (a fact now painfully visible to all), but the gains were entirely private when compared to the "real business" funded by the second capitalist who created 25 jobs, paid immense sums in Social Security and Medicare taxes (recall these are only paid on wages, not on rental or investment income), paid property taxes on his business facilities, etc.

Which capitalist do you want in your town? The wealthy investor who may or may not spend a dime locally, or the one who creates jobs and pays truckloads of taxes?

Which one pays the most Federal taxes? The "real business" owner, of course. Which one is most at risk? Some might claim the hedge fund investor, but the small business owner can also lose it all.

The real losers when the small business folds are the employees and the local community. They didn't just lose a frequent customer at a fancy restaurant, they lost livelihoods and hundreds of thousands in tax revenues and "junk fees" paid only by real businesses.

Which capitalist is most benefitted by the U.S. financial and tax system? The ones investing in paper assets, of course; their tax rates are the lowest, their risks are lowest and their flexibility is highest. Which is the most productive?

It can be argued that the original venture capitalists who invested in Apple Computer put their capital to extremely productive use. Fine, agreed. But how many hedge funds directly funded new enterprises via venture capital? Essentially zero. How much of the Muni bond investors' capital is actually at risk and funding new enterprises? Some new company may snare a local government contract to build a new school, but this sort of spending is not the same as backing Apple Computer's launch.

Clearly, both kinds of investment are necessary, venture capital and municipal spending raised from the sale of tax-free bonds; but where does small business, which generates 80% of the jobs in the U.S. economy, fit into this picture? Some small firms are funded by venture capital, and others get local government contracts; but what businesses receive long-term funding or contracts from hedge funds?

All of this is to say that invested capital is not taxed equally, nor does it generate equal tax revenues or jobs in the community. It seems rather obvious that the financial and tax structure of the U.S. punishes the most productive capital and rewards the least productive. As long as this is the case, then we can expect the real businesses which actually generate most of the jobs and taxes to wither and die under the immense burdens placed on them while capital will flow to the low-tax, low-productivity forms of rentier non-entrepreneural "capitalism" favored by the U.S. tax laws and financial system.

Who's paying for Medicare? Not the rentier capitalist; his income is untouched because it's not wages. Who's paying medical insurance for employees? Not the rentier capitalist; he doesn't need any employees to rake in a healthy low-risk, low-tax return.

"Get America working again." Nice, but with what money, when the advantages of low taxes accrue to rentier capital while entrepreneural capital pays full freight and faces staggering risks? How many will risk their $10 million in a real business with all its high risks, high taxes and high overhead costs? Why bother?

Honestly, it's much easier to sit at a desk at home and gather long-term capital gains (which may or may not be productively invested) or tax-free earnings than put up with the guff of real business. And if this is the case, then who's going to risk everything to hire people and "get America working again"?

This is why I predict 30 million formal jobs will be lost in this Depression; it's no longer worth it in terms of risk/return to start businesses when everyone is sucking real businesses dry and leaving rentier capital lightly taxed and lightly regulated.

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Thank you, Ron H. ($50) for your exceptionally generous donation to this site. I am greatly honored by your support and readership.

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