Capital vs. Labor
On a recent podcast (don’t remember specifically which one) Eric Weinstein talked about how American capitalism has outsourced labor in exchange for capital gain. I don’t remember exact quote but I think I am correct in his general sentiment. His statement made me think about capital vs. labor, especially in light of recent resurgence of socialist points of view in America.
I have to say, I am very much against socialism, growing up in the Soviet Union gave me a pretty good idea what socialism is. Power always leads to abuse and corruption and socialism is a system where people in government control means of product and distribution of resources. That structure creates a cycle where people that govern have control of capital and means of production and use these resources to reinforce their position in power. Labor in this scenario has no power as capital has no incentive to be productive and to compete for most capable labor.
Capitalism on another hand is a system where means of production and capital in general stays in private hands. That also means that capital always gravitates to people or companies that use it in the most efficient way. That is why Amazon’s value is growing. A dollar invested in Amazon in 2010 is now worth more than 160 dollars today, where is a dollar invested in Walmart in 2010 is worth about 2 dollars today. Labor also gravitates to companies that are successful and demonstrate that they can deploy capital efficiently. In a socialist society, people that control capital have no incentive to deploy it in the most productive way, they deploy capital in the way that gives them best chances of maintaining the power. That is why capitalistic system always has much better productivity and economic growth. Productivity and growth make the capitalistic societies richer and should in theory at least help all its citizens to be better off. But for a number of reasons that is not always the case, and one of these reasons is the structure where we favoring capital over labor.
Having a social safety net in a capitalistic society doesn’t make it socialist. The question is how big that social safety net should be. In general, it shouldn’t discourage people with the abilities to contribute to the economic growth of the society to participate in such activities. But on another hand it shouldn’t leave people that need help with out it. But I digress, I want to talk here about labor vs. capital.
I think over the last 20 years America has been favoring capital more and more. A perfect example of this bias is income tax vs capital gain tax. Effectively with these taxes our government tells us that we value 1000 dollars received as capital gain on a sale of a stock a lot more than we value 1000 dollars received as a salary, and by the way, capital gains taxes already have built in advantage, these gains can grow tax deferred for many years, compounding return on the original investment until investor sells his or her shares and realize the gains. Whereas compensation we receive as a salary taxed right away.
We should not forget that there are also Social Security and Medicare tax on salaried income. These additional taxes further demonstrate disadvantages our society puts on labor. Many businesses are organized as partnerships, partners pay themselves nominal salaries and receive significant part of their income as distribution of profits, thus avoiding Social Security and Medicare tax. In 2020 Social Security wage base is $137,700. That means people pay Social Security tax on first $137,700 of their salaried earnings. I think it would be fairer if people paid Social Security tax on first $137,700 they earned regardless if it was earned as a salary, distribution of profits or capital gain.
The argument for lowering the capital gain taxes was that investments create jobs and help grow our economy. That is true, but participation in labor force, earning salary is also a positive economic activity, that creates additional capital and helps grow our economy overall. Plus, to be honest, capital didn’t need additional incentives. Capital, as I said earlier, is always looking for most efficient ways to be deployed. Unless you are keeping your money under a mattress, you money always work. Even if you have it sitting in a checking account, you may not be earning any meaningful return on your money but the bank where you are holding your deposit, is deploying your money in the most efficient way it can. We do not need to incentivize investors to put capital to work, capital always work and investors are naturally looking for best ways to deploy their capital. I am not suggesting that taxes on capital gains and other passive income should be so high that it would discourage economic activities. I think proposals by the new “woke” democrats with taxes in 70 or 90% range are simply wrong. It is wrong morally and charging these kind of tax on any income will discourage economic participation by labor or capital. People that propose these kind of rates forget that countries and states compete for both labor and capital. People can just pick up and move to another place where they would not have to pay majority of the income they make to government. Last point I want to make here before I go back to my main subject is that governments are inherently wasteful and cannot use any resource efficiently, most of the money collected as tax would be wasted. The more money we leave is the hands of the private citizens and corporations the better these resources would be used.
Lower capital gain taxes create distortions in our society, as Warren Buffet famously said, he has lower tax rate than his secretary, because she is paying taxes on her regular income and he is paying taxes on his capital gains. That loop hole is used and abused by all private equity and VC firms where general partners and limited partners pay the same tax rates on the investment returns even though general partners didn’t invest their own money.
I think, at the very least we need to reverse that situation, and bring capital gain tax to the same level as the regular income tax. Ultimately I think tax on any passive income should be the same or slightly higher than tax on salaried income. Interest earned on bank deposits, dividend and other distributions, even rent collected from real estate holdings, should be taxed at a rate higher than salaried income. The difference doesn’t have to be huge, may be extra 3–5%. I think that would be fair. Especially since these type of incomes often can be offset by the expenses incurred in the process of generating this income. Another point I find interesting, is effect it could have on the social security tax. We all pay into the social security funds every time we receive a paycheck. If this new tax policy encourage people to pay higher salaries vs. distribution of capital gains and other passive income, that would increase inflows into the social security fund. I am not sure how much it would change the picture but as the saying goes, “every bit helps”!
I like this idea a lot better than other tax ideas presented by the Democratic Party. I think the idea of taxing people based on their net worth is not a good one. Most truly wealthy people have their money invested in different companies, funds, etc. These investments are not liquid and figuring out mark-to-market value of these investments are not always easy. Paying taxes on unrealized gains will discourage investments and risk taking. Also if people have to pay tax on unrealized gains, will investors be able to write off unrealized capital loses? Plus forcing people to sell part of their holdings just to pay tax on unrealized gains would take capital deployed in a productive enterprise and give it to the government that by definition cannot use any capital productively. Unless capital is invested in high growth companies like Amazon, Facebook or Apple, many wealthy people with passive portfolios do not earn more than 5 — 6% on average per year and not all of these returns are realized right away. Taxing these returns at 2–4% rate of their net worth could represent 50% or more of their return on their capital. That type of tax would discourage people to invest in new enterprises or other risky products. Somebody could invest in a startup, and the new company could take 3–5 years to become profitable, that investment is risky as it is, paying another 2–4% tax on that investment could be enough to discourage investors from funding such new endeavors. Taxes should not be discouraging growth of our economy it should encourage it instead. Plus, as it has been demonstrated in France, when that country imposed wealth tax, many wealthy Frenchmen, moved out of the country, some moved to Belgium, some to Switzerland or America, very quickly demonstrating to the French government that this new tax was not effective at all and had a negative impact on French economy.
Ultimately, I think if we can reduce regular income tax a little bit especially on families with low income and offset that reduction by increase in capital gain and other passive income taxes, that could be a great way to stimulate the economy (giving more money to working class would almost immediately show up in additional spending). I think lowering employment tax will encourage participation in the labor force and help people with low income to do better. Additional taxes collected from the other side should offset reduced taxes collected from salaries and increase overall tax collection. The exact percentages have to be worked out by experts. But I think it’s important to restore the balance between labor and capital in this country. The preference our tax system has for the capital helps wealthy people accumulate more and more capital while people participating in the labor force are not benefiting as much from the economic prosperity of the nation. Such disbalance cannot go on forever, the strains in our economic and political system are evident and current ideas and proposals from the Democratic Party are a great evidence of this problem. Unfortunately none of the solutions proposed by the Democratic Party make a lot of sense to me.
Here’s a final point I’d like to make, if one believes in progressive tax rates, and I think most people do, then charging higher rate on passive income should be well received. People that have passive income either also working and receiving salary or wealthy enough where they don’t have to work. Either way, paying lower tax rate on salaried income would offset high rate on passive income and investors that don’t have to hold a salaried position could either pay themselves a salary or accept a higher rate on their passive income.
I am very interested to see what people think about this idea. Please comment or send me your thoughts directly. I am looking forward to all comments positive or negative. Thank you for reading my post.
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