This is an oversimplified example, but if you can understand this you will understand how taxes affect investment.

Assume you have an investment opportunity. You can invest a dollar and you stand a 50% chance of losing the dollar and a 50% chance of making $2.  If you only stood a 50% chance of making $1 you would not make the investment because if you prorated the chance of making a dollar with losing a dollar the investment opportunity has no value.

If we tax the profits on the investment at 50% you reduce the payoff to $1 and you drive the value of the investment risk to zero. No rational investor would take the risk.

The closer you take the tax rate on the profit to 50%, the less likely one is to take the risk in this simplified scenario. ( One can argue that this is offset by the tax deduction of losses.  At the risk of complicating this example, taxes on gains are due in the year they are earned. Losses can  be applied against gains, but after that the tax payer is strictly limited to how much he can apply the losses against income in any year. Because of this the investor does not consider the value of a one dollar prospective tax loss equal or even close to the value of a one dollar prospective dollar profit.)

Currently the tax rate on capital gains is 15%. We are expecting Congress to raise it to 20%. The new health care legislation will now add the Medicare tax to investment income, up to 3.8%.  Added to the expected rate of 20% we are now looking at a rate of 23.8%, and increase of 58% over the old rate.  This is a big jump in taxes on investment return and it will substantially reduce the incentive of the investor to take risk. 

This new high investment tax rate will alter investment actions. One will be less likely to take capital gains and thus money will be allocated much less efficiently. Many investors expecting this new tax have likely pushed capital gains into prior periods to avoid the tax. They will also be less likely to make long term investment. Perhaps they will more likely invest in unproductive assets such as art that they can enjoy without producing income, or antique cars, jewelry,  or other consumable or collectable assets that will not generate a visible income to tax.

The result will be less investment in the assets that produce jobs and innovation. And with the reduction in investment assets,  the government will see a reduction in capital gains revenue in spite of the rise in the rates. Economist Arthur Laffer has demonstrated this effect repeatedly in our history of tax increases and decreases.

One can rationally argue that it is unfair for wage earners to be required  to pay the Medicare tax on earned income,  and to allow the wealthy  to avoid  paying  it on investment income. This may be true but it is irrelevant.  Money will go where it is welcomed, not where it is needed.  Is the urge to redistribute worth the action to reduce investment, innovation, jobs and ultimately the amount of dollars to redistribute?

Risk is more than the mathematical calculation; it is hazard plus outrage.  Like it or not the wealthy have options that Congress cannot control.  While the Congress may have been able to bribe and intimidate to barely get the votes they needed for health care reform, they neglected to consider how the investor votes.

Investors can vote with their dollars, with their hearts,  and with their feet.

Henry Oliner

Blogs at www.rebelyid.com