A philosophical question: how can there be any returns, in aggregate, to capital as such?

Allow me to elaborate. You have a pile of money. You want to invest it. Where do you put it?

Well, you might invest it in a business of your own creation. But let’s say you don’t have either the head or the stomach for entrepreneurial activity. So instead you invest in somebody else’s venture: a bakery, let’s say, that a friend wants to start.

Let’s say that baker friend has no money of his own to invest in the bakery, and you are the sole backer. He does all the work, and you provide the working capital. So you split the business 50-50.

Say the business is a success. For five years, he draws a salary, and you earn dividends. Then you sell the business and split the proceeds. From a tax perspective, the salary is taxed as wage income, the dividends are taxed as dividends, and the sale of the business is taxed as a capital gain. But from another perspective, the business is entirely the product of the baker’s labor.

Or is it? Let’s say it wasn’t a bakery. Let’s say it was a hedge fund. You’ve got the money. Your friend has the talent for picking good investments. He sets up a hedge fund to manage your money, and selects investments for you. In fact, he doesn’t select them individually himself; he creates a series of computer programs to find investments. Theoretically you could continue to operate his investment strategy if he were hit by a bus. Again, for five years he earns a salary and you earn returns; then you sell the fund – and the intellectual property embedded in the computer programs – to an investment bank.

Again, it looks like he did all the work, and the value of the business is the product of his labor. But his labor, in this case, consists of making decisions about where to put money. Which is exactly the kind of decision you made in the first example: you decided to back his bakery. And, in this second case, you made the crucial investment decision to put money into his hedge fund, rather than another one.

The difference between the returns to a particular investment and the returns to an investment category is called “alpha” in the investment-world parlance. Assuming alpha exists at all (believers in the efficient market hypothesis basically have to believe that alpha is either extremely ephemeral or is completely illusory), it is the product of the labor of those involved in making decisions how to allocate capital. This is intellectual labor, but it is labor. It’s not 100% clear to me why we don’t think of it, intellectually, as such – why we think of it as a return to inert capital.

Even the difference in returns attributable to the choice of investment category is, effectively, a form of alpha. The choice of stocks versus bonds is an allocation decision. Relative to a properly neutral benchmark (I’m not sure what that benchmark should be), all investment returns – positive or negative – are alpha.

There’s obviously a difference between taking a return for labor in the form of an uneven revenue stream from a venture and taking a return in the form of a salary. But these are points on a continuum, not differences in kind. Your salary may come from a more or less viable employer – that is to say, different levels of credit risk may be embedded in your employment choice. On the other hand, part of your return may be in the form of enhancements to your human capital – you may be foregoing current income in order to acquire new skills that you’ll be able to monetize later. You may receive part of your compensation in the form of a bonus linked to performance, or even a commission; some portion of this may be deferred so that it can be “clawed back” if the business takes a negative turn in the future. Your investment in the company, meanwhile, may be more or less risky depending on the venture; dividends from one company may be more certain than an interest payment from another. Indeed, a salary from one company may be more at risk than a dividend payment from another.

What I’m getting at is this. From a theoretical perspective, in aggregate all returns are returns to human activity – that is to say, to labor of one sort or another. And yet, we tax different kinds of labor differently – we tax wages one way, and we tax returns to labor (sweat equity or the labor involved in allocating capital) differently. Lower. Much lower.

I can see an argument for encouraging risk-taking, and therefore encouraging taking returns in the form of equity rather than salary or debt. (On the other hand, I can see arguments on the other side as well.) But I haven’t heard a cogent argument in favor of engaging in the labor of capital allocation over other forms of labor. And yet our tax code is tilted in precisely that way.

All this is by way of arguing that the folks arguing for cutting capital gains in order to reduce the incidence of “double taxation” have grasped the wrong end of the stick. Leave aside the fact that not all capital gains come from investments in corporations, and that in aggregate American corporations pay far, far less than the nominal 35% rate in taxes. In aggregate, there can be no returns to capital. Capital, absent a human being engaged in the labor of allocating it, is inert. All returns are returns to labor.

We should reform the corporate income tax to dramatically lower the rate and wipe out the deductions, bringing it more into line with practice in other countries. And we should raise the tax on dividends and capital gains to the same rate at which we tax other income. Corporations need to pay something to avoid wanton creation of corporations to hide income, but it should be an internationally competitive rate. But they are not people. People are people. And when people earn a return, that is a return to their labor. Because there’s no place else for returns to come from.