Most people are pleased when the value of some asset they own soars, even if it’s because of an un- sustainable bubble. Look at how most people reacted to the widespread run-up in housing prices between 2000 and 2006. The effect is similar, whether the assets are financial ones like stocks and bonds or tangible ones like houses, farms or gold. (For me, it is 211 acres of farmland that is soaring in value right now.)
Such situations illustrate some important ideas in economic theory, with significant implications for public policy. Consider:
The wealth effect. Both research and common sense indicate that when people decide on how much to spend in any given period, they look at more factors than just what they earn in that same period.
These factors include expectations of future income. For example, graduating college seniors with firm job offers by March spend more than classmates who are still looking. People in line for large inheritances save less and spend more out of a given salary than colleagues without any chance of a bequest.
One’s own current wealth is another important factor. A 60-year-old earning $60,000 a year, but with $500,000 in a 401(k) account, may spend more than someone with the same salary but a retirement account of only $40,000.
In general, the higher someone’s net worth, the more likely they are to spend on consumption, all other things held equal. Economists call this the “wealth effect.” And as net worth rises due to increases in the value of an asset, so does spending. But when wealth decreases, so does consumption.
The millions of people who saved less and spent more because their house was going up in value each year know this only too well. Many have had to cut their spending as home values and 401(k) balances have fallen. But increases in the value of someone’s financial investments, house, farm or gold still motivate at least some level of increased spending.
People’s responses to changes in wealth or income also influence the national economy. Early Keynesians assumed that if people got additional income from some stimulus program, like the current temporary deferral of FICA taxes, they would spend it. But Milton Friedman and other critics of Keynes pointed out that people take a longer-term view and smooth out lifetime consumption by saving large chunks of temporary windfalls. This diminishes the hoped-for boost of the stimulus program. Such saving is going on right now.
Tax considerations influence how people respond to changes in their assets. These include:
The bequest motive. Some advocates of estate taxes argue that these taxes do not contain the disincentives to savings and investment that income taxes do because “the person being taxed is dead.” This is highly naive, because it ignores the “bequest motivate” of wanting to leave money to loved ones. If you know that whatever wealth you leave them will be taxed, it reduces, at least marginally, your incentives to earn and save. (I personally think such disincentives in the existing estate tax are highly overblown, in part because there are so many loopholes, but to argue that there are no dis-incentives is a mistake.)
Lower income taxes on capital gains. Many economists advocate lower taxes on capital gains income than on wages or salaries as a way of motivating higher investment and thus faster economic growth.
Many other people argue for such preferential rates because some apparent long-term capital gains are much smaller, or even negative, when adjusted for inflation. But current law taxes the nominal capital gain, not the “real” or inflation-adjusted amount.
In the case of our farm, its market value has increased by at least 1,000 percent since I bought it 37 years ago. But we have had 400 percent inflation over the same interval. The real increase in value is “only” 250 percent. A 15 percent tax on the nominal capital gain would take a 22.5 percent bite out of the real gain.
The argument that some capital gains include much inflation is exploited by the large group of people who have very short-term capital gains that incorporate no inflation but want to perpetuate their favorable treatment. Hedge fund managers, who benefit from a special loophole that deems their earnings as “carried interest” and thus capital gains, are a particularly egregious example.
Perverse tax incentives. The farm probably would be managed in a more economically efficient way if I just sold it to the relatives who rent it from me. But if I did this to leave the money to my heirs, I would “realize” my capital gains and have to pay tax on it. My heirs would get less.
However, the “step-up basis” provision in the U.S. tax code means that if I leave the farm itself to my heirs, no tax will ever be paid on any of the increase in value between the day I bought it and the day I die. My heirs would have at least an additional $100,000 to spend that the heirs of someone who accumulated an estate from wage or salary income would not have. This is an injustice. It also means that as much as 30 percent of all the capital gains income in our economy never is taxed. (Think of how much of Sam Walton’s or Bill Gates’ wealth would fall into this category.) At more than $60 billion a year, it results in a greater loss of revenue than the much-better-known deductibility of charitable giving. But no Congress in the past 70 years has ever even approached eliminating this loophole that makes our economy less fair and less efficient.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.