On January 24th we wrote a blog titled The Most Insidious Tax. In the blog we criticized the wisdom, or lack thereof, in increasing the tax on capital gains from 15% to 20%. We have decided to expand further on the topic of capital gains taxes, and to speculate on how the economy might change if we could move from fiat money to an economy that uses capital as money.
What is the historical long-term average rate of return to broad productive capital? In terms of the S&P 500 Index, an index composed of the 500 largest U.S. companies, the average annualized total rate of return has been in the range of 9-10%. This total return is composed of dividends and price appreciation. Presently the average tax rate applied (capital gains and income tax on dividends) takes away 20% of this amount. Thus, going forward we might reasonably expect an after-tax return of about 8%.
In addition to taxes, inflation also impacts returns. Historically, the average U.S. inflation rate has been 3%, which has reduced the annual rate of return to capital when measured in real terms. Using history as our guide, as a consequence of taxes and inflation the real, after-tax return to owners of capital in the U.S. is expected to be in the range of 4% to 5% per year.
If we move to a capital-as-money economy, the return to ownership of capital should initially surge. We will not have to pay inflation-induced capital gains taxes in an economy that uses capital as money. As was stated in a previous blog, in a fiat-money economy a negative consequence of excessive money printing is inflation, resulting in price appreciation in real assets. To the IRS price appreciation is a capital gain, even if the price appreciation is only a consequence of a higher overall price level.
By way of contrast, consider what happens when broad capital (the tools of production) is used as money. When an index share is the “numeraire,” the index share would maintain a value of “one.” In a fiat-money economy, capital gains taxes are collected on assets that change in value relative to the monetary good. Printing more fiat money makes the prices of real capital assets rise, resulting in more tax revenue for Uncle Sam. This is a hideous disadvantage to capital ownership in an inflating fiat-money economy. The elimination of this tax is a terrific advantage resulting from movement to a capital-as-money economy. When capital is money, the return to capital will be reflected in the steadily decreasing prices of the other goods and services for which a unit of broad capital can be traded. But, if capital is used as money, capital itself cannot experience a capital gain (just as presently it is impossible to have a capital gain on the ownership of a one dollar bill).
In a capital-as-money economy, reduced capital gains taxes and the absence of fiat-money inflation will make the ownership of capital more attractive. Furthermore, our present system of fiat-money and fractional-reserve banking wastes valuable savings by directing loans to frivolous consumption, rather than towards worthwhile investment in the tools of production. We need to move away from an inefficient system designed to meet voguish political agendas. Doing so would cause investment in productive capital to naturally rise.
So, using capital as money would reduce taxes on capital and also eliminate the negative impact of inflation. But there is still another advantage of using capital as money. Stock ownership becomes less risky when capital is the numeraire. Presently the dramatic swings we see in the price of stocks is largely a consequence of the veil of fiat money fluctuations. Stocks appear volatile because their prices are measured in fiat money. Elimination of fiat money makes capital appear more stable, and capital’s ownership is more attractive.
For all these reasons, we believe the initial impact of movement to a capital-as-money economy would be a surge of investment in productive capital. Ultimately the increasing capital-to-labor ratio would improve our standard of living. However, the law of diminishing returns remains fully operational. In competitive markets the marginal product of capital is also equal to capital’s rate of return. As capital increases, diminishing returns works to reduce its marginal product, and its rate of return. Ultimately, the neoclassical growth model suggests the increased investment in productive capital should persist until capital’s average real rate of return declines to 3% to 4%–equal to the average growth rate of the economy (see Capital as Money, and also our September blog titled On Equity Returns and Growth).
“So what?” you may be thinking. “Why do I care if the capital-to-labor ratio increases?” The answer to this question is important. An economy that is operating with less capital than it should have is an economy that is forgoing valuable output and prosperity for its people. It is operating below the capital-per-worker level it should be at in order to maximize sustained consumption, called the “Golden-Rule” by economists (again, see Capital as Money).
Just as the opportunity cost of an “under-capitalized” economy is staggering, the prosperity bonus to the average American of moving to an optimally-capitalized economy would be equally huge. Adequate investment in capital is so beneficial to all of us, that anything that interferes with it (inflation, capital taxes, and/or inefficient allocation of our society’s scarce savings) is to be abhorred. Put simply, productive capital is the tools that are used to produce available output for the quality of life and welfare of our citizens. If, as we believe, our economy doesn’t have as many productive tools as it should, then the gain resulting from employing capital as money looms large. Capital as money could create increased wealth, consumption, jobs, wages and prosperity for all of us. Capital is the very foundation of wealth, which is precisely why it should be used as our money.