I recently engaged in a Facebook conversation about a cartoon with the caption “So you understand how the consumer will end up paying for a tariff, but fail to realize how the consumer pays for a minimum wage increase?” Though the question posed by the cartoon was great, people did not talk much about it in the comments. Rather, the conversation gravitated to how great it would be if CEO wages were capped at no more than five times a company’s lowest paid employee’s wages and to why the U.S. should implement a Universal Basic Income (UBI) plan in response to the effects of automation and artificial intelligence on jobs. There were some decent conversations, but then came this comment:
“. . . a lot of money is made via capital gains, which requires no actual labor and is basically the same as UBI. Except only rich people get it because it requires having money in the first place.”
UBI is a plan for the government to replace all welfare programs with a direct payment of unrestricted cash to certain people. There is little consensus on who would receive UBI (Michael Munger, a respected economist, proposes UBI go to every American), how it would work, and whether it is a good idea. (People who think they know how to run other people’s lives hate the idea of UBI.)
I was stunned that so much misunderstanding could be crammed into such a short statement (and that so much miseducation could be revealed in one sentence). There is approximately zero similarity between UBI and capital gains.
Sorting out misunderstandings about capital gains is important because if too many voters believe capital gains are free money that goes to rich slackers, then voters will support policies that reduce the number of new jobs created—jobs that will be needed as machines replace workers at an accelerating pace.
Let’s be clear on what capital gains are. Capital gains happen when someone sells a capital asset at a price higher than what he or she paid for it. Capital assets are investment properties, stocks and bonds, and similar things. Capital gains taxes are imposed on such gains. Properties that are intended to be sold in the regular course of a business’s operation are not capital assets. If a non-capital asset is sold for more than it costs, the resulting gain is called ordinary income and is taxed as such.
A typical capital gain happens when a person scrapes together savings, mortgages his or her house, and gets a loan to start a business. The person works hard over many years to make the business successful for family members, employees, and customers. The person draws just enough salary to “put food on the table” because drawing more would reduce the business’s chance of success. If the business fails, the mortgage company will take the house, and the person will have a damaged reputation, a disappointed family, and no savings. If after many years of hard work, risk, and struggle, a company comes along and buys the business for more than the person invested in it, he or she will make a capital gain and pay capital gains taxes on it. (Hopefully none of this sounds anything like UBI.)
Investments are good for everyone because they enable companies to get started and grow. If there are more investments, there are more companies, and if there are bigger companies, there are more jobs and more taxes paid (though more jobs lessen the need for taxes). Fewer investments mean fewer attempts to start businesses, which leads to fewer successful businesses. Successful businesses create wealth that can be used to launch even more businesses, to generate more tax revenue (adding to the government can afford), and to create more jobs for people who might otherwise be on welfare (welfare payments subtract from what government can afford). Therefore, creating more businesses is a winning strategy.
There is another important “win” from people investing money in businesses rather than spending it on bigger and better yachts or other items. An essential feature of investments is enabling people to be more productive. If workers are more productive, they are more likely to be competitive in the workforce and to have good and secure jobs with higher wages and to be more successful in competing with everyone else in the world. Investments in both education and innovative tools and methods enable people to be more productive and competitive. An investment in education is in human capital, and an investment in innovation is in physical capital, which leverages human capital. U.S. employees are paid more than people in other countries largely because Americans are more productive and have better tools that can only be obtained through investment.
As great as those things are, many people would value another aspect of investment-enabled job creation more than the combination of all the above if they were aware of it. To see this beneficial aspect, one must first understand why people are paid what they are paid. For people who make more than the minimum wage, their salaries are dictated by supply and demand. As a general rule, the longer the queue of qualified people competing for a particular job (the greater the supply of workers), the lower the wages will be for the job. The shorter the queue, the higher the wages. This explains why highly skilled teachers often earn less than other workers whose jobs require fewer and less challenging skills. The queues for teachers’ jobs are long because of the many non-monetary rewards obtained through teaching. The queues are short for many other jobs because there are fewer or no rewards other than pay.*
As newly created good jobs are filled, there are fewer people looking for those jobs, and the supply of workers relative to the number of job openings falls. As the supply of workers looking for jobs shrinks, the amount paid to workers will go up. Think of how wages for middle and low income people have stagnated over the last nine years. Much of this stems from slow job growth and too many applicants for too few jobs. More investments would have addressed this problem.
If we want to continue to enjoy the benefits of an economy that enables quality jobs to exist and grow in number, we must facilitate heavy investment in our people, tools, and methods. If we reduce expected gains from investments (by taxing more or otherwise), there will be less investment, poorer results, fewer jobs, a diminished ability to compete with other countries, and continued stagnating wages.
The big picture is that people have accumulated wealth because they have sold something to people who valued that product more than they valued the money that bought it, i.e., the buyers gained from the purchases. And the seller gained too. Since such exchanges are voluntarily, they would not have happened if the results were not mutually advantageous. Both parties to the transaction may have wished it was more advantageous, but if wishes were horses, beggars would ride.
People mostly have three choices when it comes to surplus wealth: put it under a mattress, lend it, or invest it. Money under a mattress does no good. Loans pose a relatively small risk, but they result in a relatively low income compared to possible gains from equity investments. Loans are also less rewarding because their interest is taxed as ordinary income, but they still enable people to grow their companies and create jobs.
Businesses cannot borrow much without sufficient collateral. Collateral comes from equity, and equity comes from investments in companies. Without investment there would not be companies. People who invest in companies bear the substantial risk of losing some or all of their investments. Unlike UBI, the gain from investing money is not a free ride.
These facts reveal the biggest difference between UBI and investments. To receive UBI you are not required to have done anything (e.g., availed yourself of education or work opportunities), and UBI recipients never need to take financial or reputational risks. With a few exceptions, one must have first worked hard and provided a great deal of value to other humans to accumulate investment capital. More important, one must risk losing capital to make money from investments. The more one invests, the more one has at risk. Stock market and individual company crashes have caused many a millionaire to go bankrupt. By comparison, a worker suffers the relatively minor inconvenience of having to find another job, and a UBI couch potato need not trouble himself at all.
To cap it off, capital gains are taxed, and UBI would not be taxed.
UBI may be part of America’s future. It cannot, however, be justified with the theory that the rich get free money.
*This is also why talented CEOs and other top executives get paid so much. Rarely are there queues for these people. Top executives already have top jobs with great pay, benefits, and perquisites. To lure them away from their current jobs and uproot their families to solve company problems will cost a great deal. If they are good as expected, they will make a company much more than they cost. When top executives can make yacht loads of wealth for a company (which, of course, is what is left over after the CEOs are paid), they are worth their salaries.