Jude Wanniski
October 9/10, 2004


From:Jude Wanniski
To: James K. Galbraith <galbraith@* * * * *.edu>
Re: Deficits
5:57 pm 10/10/2004


You think it is rational to tell a prospective investor that if his investment succeeds, he will get a lower after-tax reward? That's what you are saying, Jamie. The market will not permit this to happen over the expanse of an economy of 300 million people. Your argument reminds me of Herb Stein's insistence that people will "work harder" if their incomes are reduced by higher taxation, in order to hit their objective living standard. Herb told me decades ago that he came to this conclusion in the late 1940s when, as a young economist, he interviewed scores of CEOs who told him they were not motivated by lower taxes. In other words, you could tax away 99% of their marginal incomes and they would still show up every day and work like hell. Well yes, but is it the objective of economic policy to make people work harder tomorrow to produce as much as they did yesterday? I think not. Economists must always be looking for ways for the work force to produce more with less effort. Which means encouraging capital formation. Labor cannot improve its condition unless it has more capital in its hands. If you want to spend the rest of your life arguing for redistributionist policies, that is a worthy calling. No kidding. But if you want to spend the rest of your life devoted to economic growth, leaving it to the Krugmans of the world to press for redistribution, you have to become an entrepreneurial capitalist. I don't see any other logical way to go.


At 06:40 PM 10/10/2004, you wrote:


To get down to brass tacks, explain to me why you think this is so.  Isn't it just as rational (if not more so) to *increase* the riskiness you accept (the length of your long shot) when you invest your capital when the tax rate on potential gains is high, than when it is low?

If I have a target after-tax rate of return as my objective, this is correct. With a low tax rate I can satisfy my goals without taking very much risk.

It isn't correct in your model, I suspect, because you are placing enormous weight on possible alternatives to entrepreneurial activity, such as consumption or leisure.  But in the real world, it seems to me, there are real limits to the amount any one person or household can increase consumption. And if I happen to choose leisure, then the capital I would otherwise control is turned over to someone else to manage, and the logic facing that person is the same.

If the argument turns on evidence, then it would be good to evaluate the effect of tax changes (say, in 1993) on (say) the investment boom of the late 1990s.  But my impression is that your argument is mainly one of economic logic and motivation, and my counter is that economic theory doesn't give unambiguous guidance on the point.


4:52 pm 10/10/2004
Dear Jamie:

In my analytical framework, lowering the tax on corporate profits has little effect on economic growth. When I incorporated in 1978, I put my own capital into the business, $20,000, all I possessed except for the small amount of equity in my home. In the following 20 years, as a Sub S corp, I never paid any federal or state business tax. Why? Because every time I saw profits emerging as the calendar year unfolded, I made sure I reinvested cash flow into business expansion. I hired more people, analysts and marketing. I came to see the corporate income tax as an event in the life of mature American corps, those that had most of their capital gains behind them. I'd already seen this in early 1978 when the late Rep Bill Steiger floated the idea on the Ways&Means Committee of halving the capgains tax, and going one at a time to his colleagues on both sides of the aisle and winning a majority of the committee for his proposal. When the news came across the DJ wire, the DJIA jumped 20 points as I recall, a huge percentage increase back in 1978. The most instructive news came from the Business Council, representing the Top 50 US corps., which immediately announced opposition to the Steiger Amendment. The Council had no interest in capgains because it wanted the implied revenues to boost their own bottom lines. The NAM also came out against Steiger, but when I wrote a lead editorial in the WSJ, "Stupendous Steiger," noting in the lead graph that the NAM had opposed it, the phone lines lit up at NAM HQ in Washington and they came out sputtering that they now favored Steiger.

My point, Jamie, is that while I absolutely respect your intellectual integrity and believe you believe what you do because your starting assumptions led you inexorably to your macro positions, that it must make you wonder why your idea, and Vickrey's, favors the fat cats and not those at the bottom of the pile who aspire to become mature Fortune 500 companies someday.

As for Say's Law, you really should tell me why my thesis on the Crash of 1929 is incorrect. It was because of the Crash and the Depression that followed that JMK opened his general thesis with the announcement that Say's Law of Markets was obsolete. Unfortunately, JMK was in London when the Crash occurred and never got wind of the conjunction of Smoot Hawley and the Crash. If he had, might have been less certain in his belief that the old world of JBSay was gone for good and a new world of the management of aggregate demand had arrived. Don't you think you are in the position of defending the ramparts of your father's expositions on the Crash and the Depression? Why don't you ask him?

In any event, there was no tax on capital in the days of JB Say or Walras. And economic theory did not stop with those good old boys. The fact remains that an American cannot book a capital gain unless he has first invested after-tax ordinary income in a venture he believes will be successful. The American with that capital will more likely invest in long shots when the capgains tax is zero than when it is 35%. If you want to say that ain't so, tell me now, Jamie, and I will wrap all this up as a venture on my part that turned up a dry well.




At 10:40 PM 10/9/2004, you wrote:

The 900,000 small businesses include sub-chapter S corporations -- Bush included! That was the point about the timber interest.  A ridiculous definition of "business."

If I have to something for the bottom line of businesses, I'm with Vickrey: I'd cut the profits tax and raise the capital gains tax to offset.  What I don't understand in your position is the belief that leaving cap gains intact helps investment.  I suppose that goes to a basic disagreement over Say's law, but there you have it.


10/9/2004 5:55 pm

I have very explicit views about deficits as I do about everything else in the macro world. When I advised the Russian Federation, I recommended that they run gigantic deficits, but first fixing the ruble to gold so bonds could be sold by the government to finance massive public works projects. The theory was that after 75 years, the state owned practically all physical capital, more than 95%, and the masses of people owned 5% or so, ruble savings and family plots on the collectives. So no, I am not a deficit hawk in the sense that I mindlessly support tax increases or spending cuts to balance the budget.

But the deficits can be the result of "bad" spending or "too-low tax rates," or both. You and JMK may think it does not matter if you borrow from the people and use the funds to dig holes and fill them up, in order to bring about a multiplier effect. I reject that kind of mindlessness, just as I think it stupid to argue as many Keynesians have that Japan and Germany did well after WWI because they had to rebuild, thus triggering aggregate demand with a multiplier effect. Old Keynesians who also argued there would be a Depression after WWII in the US because the government would be running surpluses were stumped (temporarily) when the economy boomed. They came up with a doozy: There had been "pent up" aggregate demand. I hope you have scrubbed that stuff from your junior and senior classes.

We can hash this around if you like, but I do worry that the deficits we are now experiencing will cause the political class to listen to arguments from professional demand-side economists (like Krugman) and push the wrong tax rates (those on capital) up the Laffer Curve. The economy will contract and revenues will decline and the deficits will increase. But the worst consequence is that the people will suffer, the poorest suffering the most because they do not have a cushion of financial assets to fall back upon.


PS  You can't fix the energy problem by building windmills. You must fix the dollar to gold. Read my SSU lesson this weekend.

PPS  The reason I engage you in these discussions, Jamie, is that I still hope you will be able to make the marginal adjustments in your own outlook to be able to carry on when I kick the bucket.

At 02:59 PM 10/9/2004, you wrote:

Too small in the short run, too big in the long run. It's the right position.  You're not a deficit hawk, are you? I've never denounced Bush for the present deficits.  J