Fundamental Fallacies: Taxing Investments Reduces Investment
But he makes one statement in the course of it which he considers to be unobjectionable by all, that as far as I can tell is almost completely false. It’s one of those standard, accepted beliefs by many economists that as far as I can tell, makes no sense at all.
The marginal tax rate. If it’s too high, that actor will simply sit on its hands. If not, it will invest some amount of its $100 million.
That belief is (superficially) based on a fundamental economic truth: if you raise the price of something, people will 1. buy some substitute that provides greater benefit/dollar (demand will go down), or 2. hold cash instead.
But here’s the flaw in that thinking: there is no substitute for investment, except holding cash in a mattress.
But cash isn’t a real substitute for investment, because it doesn’t provide any benefit — quite the contrary. It just steadily disappears with inflation. If you’ve got a chunk of money, there is no substitute for investment except holding cash, and watching your money disappear.
With the exception of banks, no private entity — individual or company — holds any quantity of actual cash. (And as I discuss below, banks’ cash holding are trivial in the big scheme of things.) Their money will be in some taxable investment, whether it’s a money market, CD, treasury bond fund, stocks, or whatever. (Yes, muni bonds are an exception, but they’re a tiny component of investments.)
Facing two equally taxable investments, nobody chooses the lower return option because of taxes (which are equal). They choose the lower return because of safety, which has nothing to do with taxes.
There are two alternatives to holding cash in a mattress:
1. Small savers can opt for an (almost-)zero-interest FDIC-insured bank account. Since the government is the creator of fiat cash, that account is damn close to cash in a mattress. Those savings aren’t in a mattress, though: they’re added to banks’ reserves, which leads to #2:
2. Banks can let their excess reserves sit in the Fed. Again: fiat-cash creator, so those holdings are essentially cash. (These days, excess reserves earn .25%, so they’re just another taxable investment, which banks can choose instead of others based on projected risk versus taxed return. But let’s just call excess reserves cash.)
Everything else — every other place where money can be put — is an investment, with the returns almost certainly taxable.
So, yes: taxation creates some cash preference, but no liquidity preference — because returns on liquid investments are (almost) all taxable. (Yes, gold bugs, gold is just another taxable investment; you pay your bills — and crucially, your taxes — with money, not gold.)
Another way to think about it: you could say that cash is just another investment — a thing that stores value. It’s an investment with a negative real return and low risk. That seems abstruse and theoretical, but when actors are deciding what to do with their money — hold cash or invest — it’s the real mental calculation they go through. #2 above makes this clear.
Now you might say: if the cash preference created by taxation results in a shortage of money available for productive investments (because the taxed return on those investments doesn’t make up for their risk compared to holding cash, so banks and individuals prefer cash), the economy might suffer from a shortage of investment.
But if you believe that, you probably need to know a couple of numbers.
1. Even today, when people are quite leery of investing, cash — currency, bank accounts, and bank reserves at the Fed — totals about $3 trillion.
2. Total worldwide holdings in debt derivatives alone total something like $700 trillion. This doesn’t even consider interest-rate swaps, which are even larger, or the money in more traditional investments — stocks and bonds. The world is awash in oceans of quite liquid money, all desperately seeking investments with good risk/return profiles. A few trillion in cash is … petty cash. So taxing investments — creating some preference for cash — reduces available investment money by a small iota. (See also.)
I should add, because someone will undoubtedly go here: there is a third alternative to 1. investing or 2. holding cash — spending. But I don’t think any sane person will want to argue that if you tax investors — so they have less money — they’re going to spend more. Spending is no kind of “substitute” for investment.
Yes, obviously, taxes can have all sorts of effects on choices of investments, especially since different investments are taxed differently. And taxes create issues of avoidance and international tax competition.
But those issues are all secondary to the fundamentally false belief — that taxing investment returns decreases investment, because people will choose some (nonexistent) substitute.
It just ain’t so. They have to invest. The only question is, “which investment?”