Monday, September 28, 2015

Random thoughts about capital income

Apologies in advance if this is just boring nonsense.

I believe that it is fairly universally accepted that speculation is a zero sum game.  Actively managed funds underperform compared to passive funds, after fees.  In the aggregate, it is a mathematical tautology.  For every tactical long position there is a tactical short position.

In all economic activity, there is some allocation of gains between the producer, consumer, and those outside the transaction.  Generally, there is some positive externality from marginal new economic activity simply due to the creation of abundance, increased productivity, etc.  In the end, our claim on production - our ability to earn wages above subsistence - is a product of our available alternative sources of income.  So, generally, economic activity radiates some positive externalities that filter through to incomes in general.

On the one hand, the useful allocation of capital depends entirely on the application of skill and discipline.  Real work, intelligence, and wisdom is required.  It's hard work.  This work occurs within corporations, in private equity markets, among entrepreneurs, and among financial speculators.  If this work was not done, there would be no gains to capital put at risk.  But, on the other hand, the gains from this work are entirely captured by passive investors and consumers.

Ironically, the fact that all of the gains from this work are captured as externalities draws us into taking it for granted.  So, in the places where skilled allocators of capital do capture some of the ensuing gains as income, we see it as an aberration - as a confiscation of what should be ours.  This happens in areas where capital is allocated outside of the liquid marketplaces that modern financial markets have created - in the sphere of high growth start ups, private equity, hedge funds in illiquid markets, etc.

I think it is helpful to think of modern financial markets as an engine of liquidity.  That liquidity lowers the required rate of return on productive assets - it raises their nominal values.  This isn't just a pretend, "paper" increase in value.  It is a mistake to see value from finance as unreal and value from the production itself as real.  The value added by liquidity is real value.  The value is related to the amount of tactical asset allocation that can be captured by passive investors. Liquid valuations rise until the returns reflect the unavoidable risks of the broad basket of at-risk assets.

Before the advent of modern liquid financial markets, tactical allocators of capital captured all of the returns.  In that context, capitalists were all active owners.  They couldn't own a diversified portion of the broad basket of assets.  So, they earned gains above the level a passive investor would require, but they had to earn them through income, because those gains were only available due to the lack of a market through which to monetize them.

This is basically still where tactical allocators have excess gains.  I have gone on and on recently lately about how this is available in housing in the US today.  It's another mathematical tautology.  Returns on home ownership are excessive today precisely because homes are selling for less than the risk-adjusted returns should justify.  If constraints in the housing market were sufficiently removed so that it could function as part of the liquid basket of broad assets, prices would converge with other assets and excess returns wouldn't be available any more.

So, speculators and tactical capital allocators gain income in two ways.  First, in illiquid markets - small business owners, favored regulatory arbitrage, etc.- where it is simply earned as income.  Second, by bringing those illiquid assets into liquid markets - private equity, some hedge funds and corporate activist investors, large scale entrepreneurs.  In these cases, since the liquid market allows the value of that future income to be more profitably captured in the present, the gains are registered as capital gains.

With regard to the taxation of capital gains and capital income, then I think there are several categories.  First, there is capital income that is available to the passive investor.  This is mostly a product of deferred consumption and vulnerability to risk.  The general market price of risky assets reflects the cost of that risk, so if we want to avoid taxing deferred consumption, then general, average market gains to stock and bond holders probably don't warrant taxation.  Excess gains to owners of illiquid businesses or other assets (like houses, currently) and the gains to private equity investors and entrepreneurs from bringing assets into liquid markets may represent more than simply deferred consumption.  This income reflects the application of skilled labor.  So, maybe it should be taxed similarly to labor income.

On the other hand, if passive investment income shouldn't be taxed because it simply reflects deferred consumption, and if speculative income within liquid markets would not be taxed because it can't internalize any of the gains from the value it adds, why should these speculators and allocators working outside liquid markets be treated any differently?  In fact, maybe they aren't that different.  Maybe the required return on the market basket of goods tends to be about 10%, but passive investors only tend to earn about 9% because each year, tactical speculative investors and entrepreneurs capture 1% of the market by pulling illiquid assets into the basket of liquid assets.  Thinking of the entire system of productive assets, we might still say that, on net, speculation is a zero sum game, and passive investors are passively making tactical positions by not owning the illiquid portion of the market, and tactically adjusting their positions as those assets become liquid.  Speculators as a whole still don't gain any excess returns, but within that net total, what we call passive investors are really a set of speculative investors who consistently take losses on their tactical positions.

This is ok for them, because the prices of the assets they hold, and the required returns on those assets should still reflect the basic opportunity cost of deferred consumption and risk.  So, the required return on passively owned liquid assets should remain at our hypothetical 9%, but if speculators and entrepreneurs become more skilled or more active, the total return to productive assets might rise to 11%, with passive investors retaining 9% after taking their passively speculative trading loss.  The anchor point for all of these returns should be that passive required return - 9% in my hypothetical.  (Looking at equities - ignoring bonds, etc. - the difference between this hypothetical 9% and 11% gain can be seen, at least partially, in the excess returns of small cap stocks over large caps, over time, or in the difference between total returns as estimated by all US corporations in the Federal Reserve's Financial Accounts vs. total returns to the S&P 500.  It is a difficult thing to measure.  But, I think the large amount of innovation and entrepreneurial activity related to the tech revolution, which is an example of what I am talking about here, explain the broad public sense that there has recently been an unusual amount of capital income given the mediocre returns that traditional equity ownership has actually provided over the past 20 years - even if the 90s boom period is included.)

It seems counterproductive to see the activity that creates liquid productive assets as the one activity that is extractive or especially motivates us to tax it.  On the other hand, one could say this about taxing all value that is created by labor.  So, I think I could agree with some arguments for taxing some of the excess returns to certain kinds of capital income, but I have a reaction against the rhetorical treatment that usually is associated with appeals for this sort of taxation.


  1. Obviously I don't think what you wrote is nonsense. Have you seen;

    Timothy Taylor (Conversable Economist) has a post up about it.

    1. Thanks Patrick.

      Yes. That was interesting.