Fundamental Fallacies: Taxing Investments Reduces Investment

December 15th, 2010

Over at Angry Bear and Presimetrics, Mike Kimel makes his usual brilliant case for the stupidity of right-wing and many orthodox economic beliefs.

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?”

  1. December 15th, 2010 at 21:16 | #1

    Thank you. Nicely done.

    It also seems to me that the idea that “raising tax rates on businesses is a disincentive for investment” is another canard, for a different reason.

    The tax write off for a capital investment has more value when the tax rate is higher. I’m not sure I’d go so far as to say that the higher tax rate is an actual incentive for investment, but the idea that it is a disincentive doesn’t seem to stand up to scrutiny.

    What’s your take?


  2. December 16th, 2010 at 07:45 | #2

    This is a really really superb Post Steve, absolutely one of the best. Your points were so lucid and articulate I thought Steve Randy Waldman (that other Jewish blogger) had written it really great Steve.

    Some points from this Goyim idiot here (me): I think you should put in stress and bold print this: “Any Quantity” of actual cash…… Read that carefully Steve and I think you will agree that part of your writing “Any Quantity” of actual cash, should be stressed for the goyims like me that were just a step behind until they read it the third time.

    I think your writing here is really super awesome because of this: It makes the ppoint that you need your money invested in assets with a nice return taxwise and beneficial to society (read working assets). BUt in the end, even central banks (and of course individuals) have to transfer that value in a cost efficient manner: “cost efficient manner” reads: convenient way

    That means Cash is still KING PLease reply your thoughts on if I am right and where I am wrong in the above…..Mr. Roth (Grinning as I type that last name, not an insult or dig, but a complimental smile)

  3. December 16th, 2010 at 07:49 | #3

    That’s a drunks long-winded way to ask you Steve: Should I tell my MOm to invest about 5–6% of her retirement portfolio in a gold mining stock??? ( not Gold reserves and not A gold ETF) A Gold Mining Stock (KGC, GG)????

  4. December 18th, 2010 at 12:16 | #4

    Do I come across as that much of a jerk Steve, or you’re just busy??? Anyway the above post is great. Sorry if I sullied it. Still curious your thoughts on Gold mining stocks, really. It’s so hard to try to be “witty” and sarcastic online and get which tone you meant. I hope you no I am not a bad guy Steve, I’m really “reverse Racist” to Jews if you can except those terms.

  5. December 18th, 2010 at 12:17 | #5

    I meant “I hope you know, not no”// Oh there goes my career in writing or typing Steve, not sure which

  6. December 19th, 2010 at 21:04 | #6

    Ted: You’re right “any quantity” is ambiguous. Shorthand for “any significant quantity.”

    Jazzbumpa: Really liking that idea, thinking…

    I may have mentioned that I’m launching (actually re-launching) another business, which has me darned busy. And holiday season and all that, one daughter home from college, the other on holiday from high school, etc. So sorry for slow and short replies

  7. Kumar
    December 29th, 2010 at 14:49 | #7

    Seems to me that the rate of return on investments affects the invest or spend decision. And the tax rate affects the rate of return on investments, so if you accept the last sentence than tax rate increases, absent any other change, would reduce investment and increase spending.

    The above likely doesn’t apply to my cleaning lady, who consumes all her income and doesn’t invest anything. Likely does not apply to Warren Buffet either for the opposite reason. Does apply to many of us in the middle, at least at the margins.

    Disingeneous on your part to say: “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.” Applies to my cleaning lady and Warren Buffet but not to me, and I suspect, not to you.

  8. December 29th, 2010 at 16:00 | #8

    Kumar, at first I was going to say “I don’t understand,” but I think I’ve figured out what you’re saying.

    Say I have a million dollars and I”m figuring that’s how much I want to leave my kids. (The hell with inflation; they get what they get whenever I die.) I’m not gonna touch capital. (Though to make this simple I will let it decline in real value with inflation.)

    That leaves income only.

    Let’s say I can earn 6% a year on that million dollars — $60,000.

    A. I’m taxed 20%. I have $48K a year to spend.

    B. I’m taxed 30%. I have $42K a year to spend.

    Am I going to spend *more* in scenario B??

    But here’s the point I think you’re making:

    Taxes create an incentive to spend out of savings — especially since spending is “sticky” (if your kids are in private schools, for instance, or if you don’t want move and buy a cheaper house).

    So taxing investment doesn’t increase spending by investors (see A and B above), but it does increase spending from savings — shrinking the pool of financial investments. So in that sense spending is an “alternative” to saving.

    Since almost all savings are put into financial investments, “investments” go down due to taxes even while spending stays the same.

    So in essence — for everyone but the bottom tiers who save nothing — taxes are transferring private savings to the government for its various uses — spending, debt reduction, etc.

    But we knew that already.

    But we also know (previewing my next post) that private financial savings (corporate and personal) exceed the “capital base” (created via fixed private capital investment, minus depreciation) of residences, plants, equipment, software) by at least 100 to one.

    Fixed private investment is not constrained by an insufficiency of private financial savings. There are oceans of savings out there. So shrinking that financial savings pool a bit does not reduce fixed investment (significantly).

    And fixed investment is what we care about; it increases labor productivity, thereby delivering the Adam Smithian utopia: less work, more stuff.

  9. January 16th, 2011 at 12:20 | #9

    This is a lucid and well written argument for why we should put the pure crowding out theory to rest. It’s really just a bogus argument thrown up to block any sort of public investment. It all just amounts to a slogan: “Markit Good Gubbamint Bad!”.

    But I do have one bone to pick with this post. “Total worldwide holdings in debt derivatives alone total something like $700 trillion. This doesn’t even consider interest-rate swaps, which are even larger[.]” These two sentences are completely worthless elements in the argument. What matters in the derivatives and swap markets are the amounts of money that change hands. I don’t have a source at hand that shows how much that actually is but it is a small percentage of the notional amounts that you erroneously referred to here as “holdings”. In fact derivatives and swaps aren’t even technically “holdings” they are bets.

    I personally think you messed up this really excellent post by trotting out what I call the “I know a really big number” argument.

  10. January 16th, 2011 at 14:19 | #10

    Leroy: I had some qualms tugging at the back of my brain when I wrote that about derivatives, didn’t stop and think long enough. Thanks for pointing out the inanity. I’d take it back but you pretty much have to leave your stupid utterances standing, or the blog has no credibility. Won’t make that error again…

    FYI, I’ve got a big post on american assets (fixed and financial) that I’ve been working on for a while, will get it up soon.

    Sneak peak: U.S. financial assets held by businesses, households, and nonprofits, 2009: $55 trillion.

  11. January 19th, 2011 at 12:09 | #11

    Yeah, sorry I was a little harsh on you there. We all make errors. I really like your blog. I just think that the “I know a really big number” argument is something we should belittle the other side for using. Like when they screech about the $700 BILION stimulus. That’s not very much money in an economy with a GDP over $12 trillion.

    It also comes from my outrage that the banks were allowed to foul up an actually very promissing thing like subprime mortgages. And I’ve seen this number thrown out there by people who claim that derivatives and swaps are all just evil voodoo. No, those are useful instruments for many very legitimate hedging needs.

    I can’t wait till the big post! @Asymptosis

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