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Recently the U.S. government raised the long-term capital gains tax rate from 15% to 20%.  Think for a second what this means.  Think what a “capital gains tax” really is in a fiat money economy.   It may be the perfect tax for targeting and destroying what remains of private ownership and freedom.  Why?

When a government or central bank prints worthless fiat currency, such as our Fed does, it steals real output from the private sector by issuing a currency that is steadily shrinking in value in exchange for real goods and services.  This is what is referred to as an “inflation” tax.  It can be collected by counterfeiters and especially the largest counterfeiters of all—central banks.

Now simple logic tells us that the more a government abuses its monopoly of printing new money, the higher the inflation tax will be.  Therefore, the higher will be the appreciation of all real goods and assets measured in terms of fiat currency.  So when these goods and assets are traded, the higher, therefore, will be the realized “capital gain.”  Talk about gaming a rigged system.  The government will get you coming and going.  First, with the inflation tax and then with the arbitrary capital gains tax collected in terms of an increasing value of real goods and assets measured in terms of its weakening currency.  It’s a perfect example of the government having its cake and eating it too.  Practiced to an extreme, it’s perhaps the ultimate scheme for destroying private property.

Now consider how such a “tax” would work in a world using capital as money.

Of course, “capital gains” taxes would not be collected on appreciation of broad productive capital because, as money, capital would be the numeraire good in which all other goods and services were valued.  That is, by definition the value of a unit of broad productive capital in terms of itself would always simply be just 1—as the value of a single unit of any money is always just a unit of itself.  Therefore, on average, there would be no “capital gains” tax on productive capital.

If such an insidious tax persisted, it would largely be de-fanged because it would only be collected on extraordinary gains of other single goods and assets relative to the average value of the money or valuation good.  Since the value of broad capital would be growing at rate over time equal to the sustained rate of growth of the economy (for a more detailed explanation see  our book Capital as Money), you would not expect to see a large set of goods or assets whose rate of return would steadily exceed that.

This is why the ownership of broad productive capital seems to us the compelling choice for money.  Imagine an asset used for exchange and valuation whose own value steadily grows over time in terms of consumption goods and services.  What a recipe for peaceful sleep by money holders!  What an antidote for a weary world historically on the wrong end of the traditional government/central bank inflation game.  In fact, “inflation” would be an alien and odd concept in such a world.  It is the primary logic for choosing capital as money.

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Bond guru Bill Gross created a firestorm when he recently asserted the “cult of equity is dying.” In the August 2012 PIMCO Investment Outlook, Gross observed that since 1912 stocks have earned an average annual real rate of return of 6.6 percent. According to Gross, this rate of return cannot be maintained in an economy whose growth rate in real GDP averages only 3.5 percent. Gross argues that if the historical trend were to continue another 100 years, it would result in stockholders owning “nearly all of the money in the world!”

On CNBC Wharton Professor Jeremy Siegel disputed the conclusion reached by Gross, arguing that the mistake Gross made was in equating “return” with “growth.” Siegel pointed out that a stock’s return in part comes from dividends, and it is entirely possible for stocks to grow with GDP at a low rate of 3.5 percent while, because of dividends, the total return to stocks is higher.

Who is correct? In a way they both are. As explained in the framework of Robert Solow’s neoclassical growth model, a stable equilibrium occurs when the growth rate in capital is equal to the growth rate in real GDP. There are an infinite number of stable equilibriums, each associated with a different saving rate. If the saving rate is low, then the economy’s equilibrium capital-to-labor ratio will be low. A high saving rate corresponds to a high equilibrium capital-to-labor ratio.

As revealed by the Solow model, in general Siegel’s analysis is correct. The return to capital, which is capital’s marginal product, does not have to be equal to the overall growth rate in the economy. A low savings rate results in a low capital-to-labor ratio, and thus capital’s marginal product—which is the return to capital—can be very high. Most importantly, the high return to capital can be an equilibrium outcome that lasts into perpetuity. The high returns are simply a consequence of scarcity.

Neurosurgeons have also historically experienced a return far exceeding that of the average of all other occupations. They likely enjoy a rate of return to their human capital investment that far exceeds the average growth rate of the economy. Why do they not end up owning the entire economy? Simply because there aren’t very many of these fortunate individuals.

However, Gross was not entirely off the mark. There is an optimal equilibrium occurring in the Solow model, where the amount of capital is “just right” in the sense that per-capita consumption is maximized. This equilibrium is referred to as the “golden rule path.” When an economy reaches the “golden rule” equilibrium, the rate of return to capital is EXACTLY equal to the economy’s growth rate in real GDP.

Stock return data from the past 100 years suggest capital has been relatively scarce, and the golden-rule path has not been reached. Going forward, should the economy accumulate sufficient capital to attain the golden-rule path, we will then have reached the point where Gross’ expectation of real returns to capital averaging 3.5 percent per year will be realized.

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