Archive for July, 2014

Let’s stick the Pitchforks in speculative bubbles instead

Monday, July 7th, 2014

A tweet from Vinod Khosla drew my attention to an article by Seattle based entrepreneur and self-proclaimed zillionaire Nick Hanauer entitled ‘The Pitchforks are Coming‘:

The Pitchforks Are Coming. Agree with Nick but need structural solution, not redistribution. Change bias for capital?

The gist of Hanauer’s article is that business people need to change their practices to increase the income of the middle class in order to encourage more consumption, increase business growth, and promote social cohesion.  Hanauer’s concerns are consistent with those put forward by Bill Gates Sr. and others in the Responsible Wealth movement aimed at creating a movement to reduce wealth and income inequality in the U.S. Hanauer argues that employers should adopt a Henry Ford style of benevolent generosity and increase salary and wages in order to avoid a social movement that in the most extreme scenario would resemble the revolution that overturned French aristocracy.

I am glad that Hanauer is drawing attention to this matter, although I think his proposed solution is wishful thinking. Company management, appointed by Boards with fiduciary duties, cannot increase salary and wages at the expense of their shareholders’ profits. So while he has identified the problem, it seems that some external force must be brought to bear. One of the most powerful forces is the tax code, because we know from experience that individual and collective behavior can be modified both positively and negatively by taxes and credits.

So I replied to Mr. Khosla

is right about the diagnosis — middle class income growth is needed. The cure? Don’t know. But taxes are part of it.

As a matter of political economy, much has been written about wealth and income inequality. My views were influenced by reading Kevin PhillipsWealth and Democracy‘ in 2002, citing Spain, Holland and England as examples of what was befalling the U.S. economy.  Phillips argued that mercantilism and manufacturing created middle classes in each nation, and that the eventual concentration of wealth led each nation to off-shore investment which hollowed out their middle and laboring classes, and to non-productive financial games, that resulted in speculative bubbles and collapse in each case.

We have certainly witnessed off-shoring of manufacturing and speculation via derivatives and other instruments, which have played a role in creating the situation that worries Hanauer.  In my view, Mr. Khosla put his finger on a key element of the problem, the preferential treatment of passive capital investment over productive labor in a quick response to my tweet:

or removal of tax breaks? or repricing labor vs. capital (an arbitrary choice thru things like depreciation allowance, MLP etc!)

I think he is right that tax breaks and credits often induce economic distortions, and that we need to restore some balance between labor and capital. One aspect is the disparity in tax treatment between capital gains and ordinary income from employment.

Buying shares of stock from another investor does not result in any new investment, since the company doesn’t not receive any proceeds to grow the business.  Other than providing liquidity, society does not benefit from such stock trading, so special tax treatment seems inappropriate.

Therefore, I favor eliminating capital gains treatment on these transactions and treating any gains as ordinary income, just like employment income, to restore some balance between labor and capital.  [How to treat losses, progressive tax rates, and whether the gains are subject to FICA is another issue].

But Schumpeter’s creative destruction is essential to the innovation that creates new markets, new jobs and new wealth, and that is definitely a societal benefit entitled to special treatment.  Accordingly I favor rewarding risk takers by eliminating all taxes on new investment in companies.

My proposed approach, originally outlined in 2007, would create tax warrants that would accompany shares of stock issued to the original investors in a company. For example, at its incorporation ACME Widgets would be authorized to issue 10 million shares of common stock, each with an associated tax warrant.  Investors would buy shares of ACME, providing it with the capital to build or expand its business. When the investors sold their stock in ACME, they would surrender the tax warrants in lieu of recording income on the gain from sale of their shares.

Say I bought 10,000 shares of ACME at $1 per share, and later sold it for $11 per share.  I would surrender the tax warrant and be entitled to exclude my $100,000 gain from my income, thereby avoiding taxes. Subsequent sales of those shares would be treated as ordinary income, fully subject to income tax.

No doubt there are issues:

  • How should we treat losses?
  • What about stock options?
  • Should the tax warrants be transferable on sale of the shares, with the original investor treating the gain/loss as income, and allowing the new owner to exercise the warrant?

But I think this approach would help to discourage some of the stock market speculation, and encourage investment in new ventures.