August 28, 2002

At President Bush's "economic summit" some tax change suggestions were made to address the problems of lagging investment activity.  The President mentioned the suggestions and then said he would think more carefully about them before deciding whether he would adopt any of them. 

In the past two weeks, the Dow Jones Average has dropped a couple hundred points only one day --the day of that summit.  Since many may have thought that nothing useful came from that gathering, I would like to keep the conservation going on stimulating investments through tax changes. 

The four major tax change proposals were: increasing the investment loss write-off allowed against ordinary income; lowering capital gains taxes; increasing the allowable contributions to tax deferred retirement accounts; and reducing the "double taxation" of corporate dividends.

With some corporate managers going to jail for violating securities laws and defrauding their investors, providing tax relief that might aid their legal defense funds may not be politically viable.  Indeed, the average investor is smarting over declines in 401Ks, which is not impacted by the above tax changes (except by allowing more to go into what has been losing investment strategies for many).

However, the issue is whether these proposals will stimulate investment and whether investment needs any stimulus. 

Most economists agree that the current recovery is almost stalling because corporations are not buying technologies and equipment.  The economic stimulus package was designed to encourage timely investment, but the mere mention of needing more stimulus suggests that the temporary change in depreciation schedules has not worked. 

Perhaps, investment is not occurring because excess capacity makes new spending unnecessary.  Inflation adjusted interest rates are unusually low but little new capital spending is happening.  Why should a change in the tax treatment of  investor portfolios provide enough new incentive to stimulate capital goods orders?

In other words, the solution to sluggish investment spending may be a robust economy.  If so, tax changes that specifically address the tax treatment of investors will have limited impact upon capital spending.  So why lower the tax liabilities of investors (who normally are relatively wealthy) if the lost tax revenue will only marginally be converted into new investment activity?

Nevertheless, some of the tax change proposals should be seriously considered. 

Although the government shares fully in investment gains (through capital gains), it only marginally shares in the risk of loss.  I would prefer that no special treatment be given to capital gains, but all losses are written off against income.  If the investor does not have enough income this year, then refunds from previous year tax payments could be used, or the balance could be carried forward in new tax years. 

As a result, investors would not avoid risk at the first drop of sales and income.  Indeed, one argument for the special treatment of capital gains is that the marginal write off of losses from taking risk distorts investment decisions.  If the government is a full partner in the gains, it should be a full partner in the losses. 

Perhaps, this dual adjustment of full write offs of losses but the elimination of special capital gains treatment cannot be approved.  At least, the size of the write-off should be raised so that it is the equivalent purchasing power of when the $3000 rule was implemented.  Otherwise, the government is allowing inflation to reduce its share of risk over time. 

There currently is little evidence that a lowering of the capital gains rate will add to investment capital.  Over time, lower rates will increase investment holdings in capital appreciating assets, but we just came through a period of over-investing.  In short, the tax code over the business cycle is not restraining the desired growth of equity investment. 

Poor investment results are causing about two-thirds of all eligible investors from maximizing their tax deferred contributions.  How much more capital spending would be created by raising the size of eligible contributions to those programs? 

(I have no doubt that higher eligible contributions to tax deferred accounts will grow the size of tax deferred accounts, but most of those resources would come from taxable equity type holdings.  The government loses revenue but the economy does not gain activity in that case).

There is a problem with the taxation of corporate income and then further taxing the dividends to individual investors.  Corporations will be more reluctant to pay dividends because of that treatment.  Recent experience shows that stocks with dividends that do not undermine the cash position of corporations have less volatile prices than stocks without dividends. 

If corporations could expense their dividends, encouraging higher payouts, then stock volatility might be reduced. 

There is much more to be said on all these proposals, and they probably should get a full hearing.  Somehow, I believe this administration will forget them as quickly as the public has forgotten the "economic summit."


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