Republican and Democratic big government advocates whine about President Bush's proposed tax cuts, particularly cuts in the capital gains tax. They say it's a $70 billion giveaway to the rich. Listening to demagoguery about the rich, I've sometimes wished that we could find a humane way to get rid of the rich so that we might better focus on what's in the interests of the other 99.44 percent of us.
Let's talk about capital gains taxes starting out with a few questions for you. Suppose you see a couple highway construction projects. On one project, the workers are employed using shovels and wheelbarrows. At the other project, the workers are using huge earthmovers, cranes, asphalt-laying machines and other equipment. On which project do the workers earn the higher wage? You'll probably answer, "Those on the project with all the machinery." Now the question becomes, why? Is it because construction company owners like machine operators more? Or, is it because the machine operators have more bargaining power?
The answer to both questions is no. The correct answer is that the workers on the project using all the machinery are more productive. They are more productive because they have much more capital (equipment) working with them. As a result, more road is built per day, per worker, and their wages reflect that higher productivity.
Creating more equipment, whether it's earthmovers, computers or technical innovation, is called capital formation. The capital gains tax is a tax on capital formation, and when anything is taxed, one expects less of it. Less capital formation means a slower growth in wages. Roughly 95 percent of the growth in wages over the past 40 years is explained by the capital-to-labor ratio.
The capital gains tax dampens risk incentive. Put yourself in the place of an investor. You can invest in a utility company that's been earning a six percent rate of return for decades. Alternatively, you can invest in a high-tech, high-risk startup company. While such an investment has a high risk, and you stand to lose all of your money, success can deliver a potentially very high payoff. Capital gains taxes reduce your rate of return on the risk you have taken. Reduced rates of return mean that people will undertake less risk.
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