Inflation

Why Taxing Wealth is a bad idea?

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.

For example:

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.

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Monetary Policy and Income Equality

by Alex Merced

In a previous article I discussed that redistribution of income isn’t necessary to create equality, instead you should unleash market forces by reducing barriers into wealth markets. In this article I’d like to make the argument that another culprit in creating growing inequality is not only market controls but monetary policy, especially expansionary policy.

What is Monetary Policy?

Monetary policy is a policy tool, often controlled by central banks, that revolves around the control of a country’s money supply and credit. Monetary policy mechanisms usually consist of interactions with the banking system that make it easier or harder for banks to extend more credit. A couple of major mechanisms include:

Discount Lending: When banks have liquidity or solvency issues they may borrow from other banks to keep things going, but when there isn’t a bank to borrow from they can go to the central bank and borrow against typically high quality assets(“safe” stable liquid assets like government debt). These loans are usually in the form of deposits on the banks balance sheet (record of asset and liabilities).

Open Market Operations: Another way of getting money in and out of financial institutions is to enter short term contracts called Repurchase Agreements (repos for short) where the Central Bank lends money by purchasing an asset today with a contractual promise the bank will repurchase it from the central bank in coming days (the reverse of this is called a reverse repo when central banks need to take money from the banks).

Quantitative Easing: Similar to open market operations without the agreement to repurchase, basically the central bank outright sells or buys assets depending on their goals which can have the largest impact of three mechanisms discussed in this article.

What are contractionary and expansionary policy?

The central bank usually conducts either contractionary policy or expansionary policy:

Expansionary Policy: By increasing the amount of money in the economy (usually in the form of lending to banks) the amount of credit available increases. This is usually done when  central banks are worried about unemployment (due to what I believe is a misguided belief in a trade-off between unemployment & inflation). So by inflating the money supply several things happen such as…

– The lowering of real interest rates (rates after inflation) makes it unwise to hold money, or even relatively safe investments (since the return will still be negative after inflation), encouraging investment in riskier higher return investments

– Lower interest rates will encourage more borrowing (although the lower rates would discourage lending, the low real rates make it even worse not to).

Contractionary Policy: By decreasing the amount of money in the economy you end up with the opposite result.

How does this affect inequality?

While inflating the money supply may not immediately in the short run inflate the price level, it can have several pernicious effects on the distribution of wealth.

1. Drives up the prices of capital goods: the low nominal and real rates will make longer term, capital intensive investments more attractive resulting in driving up the prices of capital (natural resources, property, etc.). The result is that this increase in capital asset values increases return to the owners of capital (often the wealthier portion of the population) and squeezes out the resources available to firms to pay labor even if the purchasing power hasn’t depreciated yet (the low income population depends on wages a bit more).

2. Financial assets will also be driven up in value: Since financial institutions are the mechanism for increasing the money supply, money that isn’t lent will often go into buying financial assets like stocks. One signal that prices of stocks may be drifting away from the real value of the company is rising Price/Earning Ratios (often referred to as expanding multiples on financial television). This means the owners of financial assets (often the wealthy) get a pseudo-free gain on their assets increasing disparities in wealth. This is often justified under the idea of the “Wealth Effect” that people seeing their assets increase in value will spend and invest more.

While there is nothing inherently wrong with consumer prices and asset values rising, the intervention of the central banks creates a one sided arbitrary and regressive redistribution of wealth in the name of financial stability.