by Alex Merced
In his new book, “Capital in the 21st Century“, Piketty advocates for a global tax on wealth as a way to curb growing income inequality. Of course, as a libertarian you can probably guess I think this is a bad idea but for good reason. I have discussed income inequality in previous articles I’ve written, and disagree with Piketty that the correlation between the return on capital and income inequality means the capital growth is cause of the inequality (thus taxing it the cure). Instead, I believe my other article on how monetary policy and inflation increase income inequality not only explains the correlation (inflation increases returns to capital and decreases return on wages) but also just makes more sense in explaining the trends discussed by Piketty.
Although in this article I’m less concerned with what is the true cause and cure for income inequality, but with how bad a solution a global tax on wealth would be. Taxing wealth would not only have the effect of reducing and confiscating wealth which of course is abhorrent from a libertarian perspective, but it will also make capital gravitate to more risky investments than they otherwise would, destabilizing the capital structure of the economy.
So why would higher taxes mean riskier investments?
From an investors point of view, you are generally not just looking for a high % return but generally a return after you adjust for inflation and taxes. The higher the taxes and the higher the rate of inflation the higher return needed to survive both.
Let’s say you have a 10% (which is pretty good) with a tax rate of 35% and inflation rate of 3%
After taxes you will have a 7.5% return (10 – 35%)
Adjust that for 3% inflation (7.5 – 3)
your at a 4.5% return (and this ignores state and other taxes, also ignoring any issues in measuring inflation)
The point being is that as the hazards of inflation and taxes build up, one must seek more return and the name of the game is “more risk, more reward” meaning that higher returns will be found in increasingly risky investments.
Why do riskier investments return more?
Imagine a world where investments of all levels of risk gave you a 10% return, which one would you choose to put your money in?
If you answered the safest, that would be quite rational and would be what many others would do as well. The result is, that everyone wanting the safest investment will bid up the price which in turn reduces the return on investment (your giving up more for the same thing) and the return will continue to go down until the return goes so low it’s not worth it to investors to bid it any higher.
These investors would then do the same with the next safest investment, etc. By the time you start getting to the riskier investments there will be less potential buyers so they won’t be bid as high, and when you get the riskiest of investments they may be bid down (because maybe 10% return is not worth the risk) so a lower price would give you a higher return (giving up less for the same thing).
Bottom line, investments are generally priced heavily based on risk and reward. So more taxes and inflation will just lead to an increased demand for risk, which at some point will create a scenario that bad investments may outweigh good investments and growth turn into a slump.