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SEIFFE:  Obama Strikes Out

Friday, April 25, 2008

By Ralf Seiffe

Children, especially those enjoying premium educations, seem to be enthralled with Barack Obama when he invokes the notion of “change”. While the candidate’s definition of change remains largely unexplored, my high school son tells me that Obama’s promise to repeal the “Bush tax cuts for the wealthy” is popular with his friends. They should reconsider because the junior senator from Illinois’ position on capital gains--the centerpiece of the “Bush” tax cuts--shows he’s neither the candidate of change nor a candidate with young people’s interests in mind. So, in the hope that one or two of the next generation are still open to discourse, let me make the case that Obama is not your friend.

Let’s start with the basics.  When one puts money in an investment--say a hundred shares of Google--the hope is that the price of the shares will increase and that the company will pay regular dividends.  Under our tax law, the dividends the company sends to the investors are taxable as regular income.  On the other hand, the rise in the price of the shares is not taxable until they are actually sold.  When the shares are sold, the difference between the price paid for them and the price received is the “capital gain”.  This gain is what is targeted by the capital gains tax.

Capital gains taxes are really an exit fee on investments.  It’s important to understand this and to also understand that when any activity is taxed, the taxed activity always diminishes.  So, it stands to reason that when there is an exit tax on investments, there will be fewer exits.  As the tax rises, there will be proportionately fewer exits.  The opposite is true, too, when the tax is lowered, more exits from existing exits occur.

Investment capital is a scarce resource.  In fact, there are more investments available than there is capital to fund them.  Markets exist to ration the capital to the most promising projects based on the expected, future performance.  When capital flows freely, we get all sorts of valuable changes in the form of new products, services and most of all, better jobs.

The trouble is capital gains taxes act to raise the price of exiting one investment to make that capital available to invest in a new project.  This means that high capital gains taxes tend to keep capital in existing investments rather than being “ex-changed” for new investments.  In other words, capital gains taxes are the enemy of change.  Strike one for Obama.

You may be thinking “So what?  This doesn’t affect me, just the wealthy.”  Think again.  In the next several years, many of you will conceive world-changing ideas.  You will know the real value of your idea and your contemporaries will instantly understand your brilliance.  You will dream of making a difference in the welfare of the world and foresee bringing your friends in as employees, lawyers, bankers, marketers and, of course, customers.  To realize your vision, however, you need investors to put up the capital to start the venture. 

Your first job, then, is to convince investors to sell their current investments to put their capital in your idea.  Unfortunately for you, these old folks have already put all their money in the investments that were popular in their youth.  Over the years they have developed large, taxable gains in those investments which, by the way, gives them the capability of helping you.  But, to move their money into your deal, they will have to sell their existing assets and, when they do, they will have to pay taxes that divert funds from your project to the government.  The investor has to sell more of their assets to write a check to you and the government in order to pay capital gains or investment exit taxes. 

To compensate for these taxes, investors will demand a higher return from your deal.  That means my generation (the ones with the money) will demand more of your generation (the ones with the good new ideas).  This usually takes the form of taking greater ownership positions in the companies you and your contemporaries will start, leaving you with less.  That a direct consequence of higher capital gains taxes and it clearly hurts your generation’s interests.  Strike two, Obama.

One more thing.  The government always receives more money from capital gains taxes when capital gains taxes are reduced.  This stands to reason because when the exit tax on investments is reduced, there will be more exits.  Since the tax kicks in only when investments are actually sold—exited--investors respond as expected and make more exits when the tax is low.  Obama was confronted with these facts during the recent debate in Philadelphia.  Asked why he wanted to raise capital gains taxes, Obama’s answer was, essentially, “It’s not about the money, it’s about fairness.” 

Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader and Illinois Review.

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