Profit Prophet

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When the news hit early this year that America Online, founded only fifteen years ago, would buy Time Warner, a media giant whose history reaches back into the early 1920s, The New York Times devoted almost two-thirds of its front page to the story. That is not surprising. At $165 billion, it was by far the largest merger in American corporate history.

It was Henry Luce, founder of the Time half of Time Warner in 1923, who dubbed the twentieth the American Century. But if this merger is any indication, the twenty-first century might turn out to be equally American, thanks to among other things the Internet, the home turf of AOL.

The Internet bids fair to be to the new century what the railroad was to the nineteenth: the maker of a whole new economic universe. And it is largely an American enterprise. American corporations collect 85 percent of the revenues from Internet business and have 95 percent of the stock market value of Internet companies. Almost half the people regularly on-line live in the United States.

The whole culture of the Net, as it is developing, is youthful, individualistic, decentralized, and mightily unimpressed with authority. In other words, it is very American. To be sure, our economic power and its technological lead would have assured a powerful American influence on this remarkable new platform for human interaction and economic activity in any event. But a major share of the credit must go to a now-forgotten congressman. William Steiger, Republican of Wisconsin, never heard of the Internet, but he understood how powerful self-interest is in motivating human beings to take the risks necessary to innovate. That’s why he worked so hard to reform the capital gains tax.

Capital gains result when a person or corporation buys an asset and later sells it at a higher price. When the first modern income tax was passed in 1913, capital gains were treated no differently from other income, such as salary or dividends. But they are different, for while one cannot receive a negative salary or dividend, one can certainly suffer a loss on an investment. Originally, investors could simply deduct these capital losses against all income.

But when the Crash of 1929 marked the onset of the Great Depression, the wealthy often found themselves holding stock on which they had large losses. By selling that stock, establishing the loss, and then buying it back immediately, these people could avoid taxes on their regular incomes without altering their control of the corporations involved. In 1930,1931, and 1932, J. P. Morgan, Jr., the nation’s most famous and powerful banker, used this technique and paid no income taxes at all.

To correct what was viewed as a gross inequity, the Congress changed the treatment of capital gains for tax purposes. Henceforth, half of all capital gains would be excluded from taxation. But, in exchange, capital losses could be deducted only against capital gains, not regular income, except for a thousand dollars a year (much later raised to three thousand).

Capital gains have other peculiarities, besides capital losses, that set them apart from ordinary income. Salaries, wages, dividends, and interest are paid at regular intervals, and thus the person receiving them inevitably incurs a tax liability on the income. But one does not have to sell a stock or building lot. If an asset rises sharply in value, there is greater and greater reason to hang on to it rather than to realize the profit and hand over a large chunk to the government. Also, in inflationary periods much of the gain may be only the effect of the inflation but is fully taxable anyway, again making the holder reluctant to sell. This locking-in effect inhibits the free flow of capital to areas of new opportunity.

And there is one more difference between capital gains and other income. By definition, before one can have a capital gain, one must have capital, which means that capital gains taxes are paid mostly by people at middle- and upper-income levels. This makes capital gains especially susceptible to political demagogy.

In 1969 the Treasury Secretary of the outgoing Johnson administration, Joseph Barr, testified before Congress that in 1967 there had been 155 tax returns filed that showed incomes in excess of two hundred thousand dollars but no tax liabilities. There had been 21 with million-plus incomes but no income taxes. This was perceived, correctly, as unfair. The cause, of course, was the endless complexity of the tax code, including such provisions as allowing state and city bonds to be untaxed.

Although the top 5 percent of taxpayers in this country in 1969, who earned 20 percent of the income, paid 40 percent of the taxes, Congress set about pursuing the twenty-one millionaires who had accountants clever enough to help them escape taxes. It passed laws requiring the payment of minimum taxes and then alternative minimum taxes. It is doubtful that all this new complexity corralled every last escaping taxpayer, but it certainly had a terribly adverse impact on the capital gains tax.