Chicago Columnist Illinois Leader Entrepreneur Political Analyst Business Advisor Illinois Review

Tuesday, May 25, 2004

By Ralf Seiffe

Our senior U.S. senator and his junior mentality often harps about “tax cuts for the rich” and he cites these reductions as proof of Republican iniquity and reason to return Democrats to power in Washington. Once there, they will presumably raise taxes on capital gains and dividends because “only the rich” pay them.

This is exactly the wrong strategy for Illinois. Our state has and will benefit disproportionately from elimination of capital gains and dividend taxes because these cuts encourage investors to recycle their wealth into new businesses. Since Illinois has a lot of its wealth tied up in old industries, we have a source of funds to start new businesses and create the opportunities of the future.

Unfortunately, left-wing Democrat politicians-as well as many “moderate Republicans”---would rather tax the recycling process and thereby slow it down. They fail to understand the real value of tax cuts and how lower burdens on capital will encourage new businesses and new jobs.

A lower tax burden is the key to Midwestern revival.

My business partner and I have just returned from a visit to a new company seeking financial and marketing assistance to launch a new product. Their new software tool distributes music and movies through the internet while protecting the intellectual property of the content owners.

They have a novel solution that allows artists and creators to expose their works to the widest possible audience while, at the same time, eliminating the risk of theft by a teenager in Terre Haute or by a pirate production facility in Asia. Anybody who has followed the battles between the studios and the file sharers using Napster and Kazaa understands why this is an interesting product.

As our economy becomes an ever-larger producer of intangibles such as software and entertainment, the ability to protect it becomes more important, so their product should have a long life.

This high-potential product needs a small amount of seed capital to make it a force in the movie business. Despite the quality of this business proposal however, raising the money will be a problem and this idea may never be realized.

One major reason is that the capital necessary is currently locked up in the “old” industries of the sort we have here in Illinois.

Potential investors loathe liquidating their current investments because they have years of accumulated capital gains. They will not sell those investments and and pay the taxes without a very high rate of return. When the government takes 15-39% of the gain on an old investment, the investor insists, rightly, that the new situation first returns those taxes.

After recovering the taxes, investors also require the investment to make additional profits to compensate for the business risk of the investment. As a practical matter, this means that new investments must return 40%---nearly four times the long-term performance of the stock market---to get consideration.

In the real world, this means an inventor with a perfect idea and an evident market will have to give 90% of his company away to satisfy investors. This substantially diminishes his incentive to go into business.

No one understands how taxes influence investment returns better than America’s second richest man.

An ostensible Democrat and surprising advocate for higher taxes, Warren Buffet has earned his way to his achievement by, among other strategies, holding investments over long periods to avoid current income taxes. He advises Californians to raise real estate taxes and John Kerry to hike income taxes, but he keeps Berkshire-Hathaway money working by not paying taxes.

Buffet’s not afraid to credit this strategy for part of his success.

But, what if the oracle of Omaha and the legions of investors who aspire to his accomplishments didn’t have to factor taxes into their investment decisions? What if they could buy new business ideas, like the software inventors we visited, without having first to recover the tax bite from selling the “old” investment?

The easy answer is that the pool of opportunities should vastly increase. For each new business idea that finds funding, there are many more that “just miss” because they do not promise the highest standard of return. Nevertheless, they are good, profitable ideas and by eliminating the taxes on capital gains and dividends, business ideas that project returns of only 25-30% would become viable.

These lower, but still satisfying returns would attract capital and become real businesses. They could---and should---be a source of many new, high-quality jobs for the citizens of our state.

The proportion of money that investors recycle into new, high-risk new ventures is a very small so the government would “lose” very little revenue by eliminating capital gains and dividend taxes. For Illinois and other Midwestern states that have lots of wealth locked up in old industries, low capital and dividend taxes are a boon that have already begun to revive our economies.

Whether Illinois is able to sustain the creation of new businesses, and the jobs that go with them, depends a great deal on the November election.

If the tax-cutters remain in power, expect to see Bush’s tax cuts on capital formation made permanent and perhaps their value be inculcated into Washington’s economic worldview. If so, Illinois will begin to unlock its old economy investments and recycle our old wealth into new industries.

If the class warfare side wins, expect their objectives to trump logic and force investors to move their capital to lower-tax environments. Capital taxes ossify the wealth recycling process and the mantra regarding “tax cuts for the wealthy” will properly translate into “more jobs for China”.

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