Investments and Tax Law

Investments and Tax Law

Economists make a distinction between physical investments and financial investments for a good reason.

Physical investments are direct inputs into businesses. Physical investments are additions of assets such as plant and equipment - plus anything that provides inventory, such as raw materials and labor. When economists talk about investments, and as long as the context doesn’t indicate otherwise, they are talking about physical investments. They are not talking about the source of the funds behind these physical investments.

When people want to make money off of their accumulated wealth through investments, they tend to be thinking about financial investments. Financial investments are purely financial instruments that are generally categorized as equity (ownership rights, or shares of stock) and debt (loans and bonds). Holders of financial investments tend to think of stocks and bonds as being their investments. They generally are not thinking of the physical assets that these financial instruments might or might not be used to purchase in the operations of businesses.

Why is this distinction important? Physical investments go directly into the economy and are used to create economic growth in the overall economy. Financial investments come in many different forms, many of which do not involve direct investment in the economy. Some even take wealth out of the economy, such as overseas bank accounts and the export of jobs instead of products produced domestically. Some financial investments are mere speculations and do nothing to produce anything in the economy. Often, when investments are purely financial in nature with no corresponding physical investment, the only things that they create are financial bubbles. We all know what happens when these bubbles burst – everybody pays.

Yet tax laws give preferential treatment to financial investments without taking this distinction into consideration. Investment income tends to be taxed at a lower rate than income earned from wages on a job. Tax laws are more generous towards investment income under the theory that investments help to grow the economy. This makes little sense as long as the same tax laws do not make a distinction between investments that actually go towards economic production, investments that create financial bubbles, and investments that take wealth out of the economy. As it currently stands, tax laws actually give investors an incentive to undermine the economy.

Although wages are generally taxed at a higher rate than income from financial investments, a much higher percentage of wage income gets put back into the economy than investment income. Wouldn't it be better if tax laws were changed in order to reward activities which benefit the economy and dissuade people from undermining the economy?

A version of this essay is included as a chapter in the book Common Misconceptions of Economic Policy by Jerry Wyant. You can purchase this book in paperback form from Amazon and other online book distributors. The list price is $12.99 (only $9.99 using discount code TA9GTK7E when ordering, depending on the distribution channel). Or if you prefer, you can download a digital version on your device (Kindle, Nook, etc.) for $4.99.

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Jerry Wyant