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Milton Friedman explains why high taxes deter investment

Taxes are incentives. If we tax something, we get less of it. Indeed, this is what so-called ‘sin taxes’ are based on.

High rates of taxation on income from investment – such as the US had until recently – will reduce investment just as rates of taxation on smoking will reduce smoking (in theory). Britain in the 1970s provided a good illustration of this. Its top rate of income tax of 83% and 98% top rate on investment income did little to bring in bumper revenues and more to send rich Brits abroad. As Rolling Stone Keith Richards put it,

The whole business thing is predicated a lot on the tax laws…It’s why we rehearse in Canada and not in the U.S. A lot of our astute moves have been basically keeping up with tax laws, where to go, where not to put it. Whether to sit on it or not. We left England because we’d be paying 98 cents on the dollar. We left , and they lost out. No taxes at all.

The economist Milton Friedman, visiting Britain in 1976, noted this phenomenon, as he observed in this Newsweek column

American tourists in London are often impressed by the number of Rolls-Royces cruising the streets and by the astronomical prices of second-hand Rolls-Royces: ten-year-old autos offered for sale at $30,000 or more. How can this display of luxury be reconciled, they ask, with Britain’s economic difficulties? How can it survive Britain’s highly egalitarian tax policies?

The answer is that those self-same tax policies, whatever their intentions, are a major cause of both the high living and the economic difficulties. Income from wealth—if received in cash form—is subject to tax at rates that reach 98 per cent at the maximum. An Englishman of wealth has the alternative of buying a Rolls for, say, $50,000—to take a rather expensive but not the most expensive new model—or investing that $50,000 in bonds or stocks or other financial forms. Suppose that he could invest in bonds yielding 15 per cent—an extremely high rate even in inflation-plagued Britain. He would then get $7,500 in annual income. However, after paying tax at a 98 per cent rate, he would have left only $150 to spend.

Suppose instead he buys the Rolls. The income he gets from it in the form of satisfaction and transportation is not subject to tax. His annual cost is the same as if he were renting the $50,000 car for $150 a year—surely, a tremendous bargain. Moreover, had he bought bonds, their value in terms of goods and services would depreciate each year as inflation proceeded, and he would get nothing in return. The value of the car too may go down after allowing for inflation but at least he is getting the services of the car in return.

To cite one actual example. On a recent trip to Britain, we met a wealthy gentleman who owned a Rolls. He had purchased the car new twenty years ago for 8,000 pounds. He estimated its current sales price as 10,000 pounds. Of course, the 10,000 pounds would buy much less in goods and services now than 8,000 pounds would have bought twenty years ago. Yet there is hardly any financial investment that he could have made then that would not be worth fewer pounds today. And, in the meantime, he has been able to enjoy the services of a fine vehicle.

Not all Rollses cruising London streets are privately owned. Many are owned by business enterprises. But these too have been encouraged by taxes. An employee would rather receive the services of a car than an equivalent amount of cash, if the cash is subject to tax and the use of the car is not. Hence, this arrangement is often mutually advantageous to employer and employee.

What is true of Rollses is, of course, also true of luxury houses and apartments, paintings, jewelry—any form of wealth that yields services in kind rather than in cash. Moreover, the same forces also encourage lavish spending out of wealth on current services. Given confiscatory taxes on current income, and steeply graduated taxes on inheritances, the wealthy Briton might as well spend his capital on high living.

But what has this to do with Britain’s economic difficulties? A great deal. The wealthy man who wants to conserve his capital does so best by getting it out of the country. He has no incentive to use it productively within Britain. The ambitious man striving to become wealthy has no way of doing so unless he too can find tax shelters. There are many tax shelters in Britain as well as in the U.S. but, as here, the result is misdirection of such investment as does occur. An additional result is a brain drain of many of the ablest young men to countries where taxes are lighter.

The government has stepped in where private investment has disappeared. It borrows abroad to finance, unwittingly, the capital flight produced by its own policies. It subsidizes private industry to replace the investment its own policies destroy.

The U.S. has not yet reached anything like the British situation. But we have been approaching it. Here too, high living is perhaps the best, and certainly the surest, shelter available to the wealthy against both taxes and inflation. Here too, taxes reduce the incentive to invest, and distort the investment that does occur. These are “loopholes” it will stretch the ingenuity of the tax reformer to close—except by the most effective of all reforms, lower taxes.

John Phelan is an economist at the Center of the American Experiment. 

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