Just what is it about the "Dismal Science" that causes otherwise rational Human Beings to throw out what they know to be true in order to adhere to abstract theorems?

Why completely forgo life experience?

I often find myself having these thoughts whenever I come across an economically based argument -- on tax cuts, on social theory, on government spending. A recent column I saw elsewhere by Don Luskin, titled "Proposed Tax Cut Isn't the Stimulant We Need" is a typical example. (I'd provide a link to the article, but the company is now out of business -- the irony of which is simply too overwhelming).

Although I find myself agreeing with many of Don's sentiments -- i.e., wouldn't a capital gains tax cut be nice -- the economic rationales for these actions have never struck me as persuasive.

I've long wondered why that is.

A starting point would be to notice that many economic theories detour away from real life to a mythical, enchanted land; its a place where all actors are rational; where individual motivation beyond financial self interest is unfathomable; a place, where in short, the abstract has supplanted actual experience.

For example, in that article, the author wrote:

"Lower tax rates increase the motivation for people to make that extra effort -- to work overtime at the factory, to get a second job, to write another symphony, whatever -- because they'll get to keep a greater fraction of the fruits of their physical and intellectual labor."

I'm sorry, but that just does not square up with life experience. People work overtime or take 2nd jobs because they NEED THE MONEY. Not because they have calculated the marginal after tax gains and feel the incentive to work due to an income tax cut. That's Conservative theorist double-speak best left to George Gilder.

No, people take another job because they have to pay rent and little Suzy needs braces and the kids want to go to camp and that junker in the driveway needs a new transmission and grandma needs an operation and the mortgage payments due and wouldn't it be nice to go on vacation occassionally and . . . You get the idea.

Real people back on planet Earth -- and not the theoretical constructs imagined by some intellectually lazy economists -- perform additional labors because they need the cash. Is it relevant to them whether that 2nd payroll check is taxed at 25% or 33% ? No, that tidbit may be inconvenient, perhaps, but irrelevant to the vast, vast majority of them.

Oh, I'm sure you can dig up someone who won't take a 2nd job because of the "tax burden." But the clinically insane are a small statistical anomoly, and not the rule.

As to those who write symphonies (or sculpt or write novels or paint), they do that because they have to, not because they want to. We can wax philosphic on that over a beer one day, but as one who writes, I'm sure Don understands what I mean. Paul McCartney and John Lennon were not dissauded from putting their songs on paper, depite the fact they were in a 90% tax bracket.

Of course, they eventually did leave England -- but that was long after they wrote their songs.

Finally, one last issue also requires a closer look:

"That's why the ultimate tax policy stimulant for the economy isn't an income tax cut at all; it's a cut in the capital gains tax. If you give the people who control America's wealth incentive to put that wealth at risk, then those extra jobs will be created and those new symphonies will be staged. That means not just more spending."

While I do not disagree with a Capital Gains Tax Cut, I find this rationale to be utterly laughable.

Under the present "disincentive" capital gains laws, we have seen an inordinate amount of venture capital invested -- on the order of hundreds of billions of dollars the past few years, and trillions if you go back a full decade; It is obvious that the present capital gains taxes have not dissuaded investors in the least, or provided a disincentive to put wealth at risk.

Despite the cap gains "burden," we have created many jobs and symphonies and even pets.com.

If those arguing for a further reduction in capital gains had had their way, could you imagine what the bubble would have looked like with even MORE capital investment? That's simply too frightening to contemplate.

So if the present cap gains rules have not disincentivized investors, why the rush to change it? Why the slavish dedication to unproven, dismal theorems? "A cap gains cut would produce even more investment" is the usual repsonse. That does not hold up upon close examination:

I think we would all agree that at 100% cap gains, no investor would risk anything -- and therefore all investment grinds to a halt. If the cap gains were taxed at 0%, there would be a (theoretical) maximum incentive to invest. But consider the actual small cap gains cuts being proposed -- do you actually think human beings will alter their behavior for these subtle differences?

Humans seem to barely have the capacity to discern major life threatening events. For example, we all know smoking causes cancer and seatbelts save lives - yet many people still smoke or don't use seat belts. Where is the rational, self interested behavior economists are always discussing?

Will a VC, or investor or fund manager -- indeed, most any person -- alter their behavior significantly in response to the cap gains taxes going down to 25% from 30%? How about to 20%?

Obviously, a huge drop -- lowering the cap gains tax by 90% -- would have a some impact -- but that is not on the table. Washington, DC is a land of incrementalism; The incremental alterations which DC has become so enamored with has a neglible impact on real life behavior. And you know what? We Americans actually like it that way -- we are too wealthy a society to truly rock the boat.

Want to know a good reason why the Capital Gains Tax should be cut? Its because we have created a very pleasant Meritocracy in which to work and live. We rewards talented producers and creators of goods, services and wealth. Talented investors should keep more of their gains because they are performing a service -- bringing capital to the markets; Consider it a merit raise. Untalented investors get a tax write off as their consolation prize.

Small numerical shifts in government tax rates have an imperceptible impact on actual human behavior. Like so many other items, tax numbers are relative. If the rules were changed to make a football field 95 yards long; if baseball had 5 balls instead of 4 for a walk; If the baseketball hoop were 2 inches wider -- everyone would adapt to the new order, and these changes would be just part of the background noise.

So, too would an incremental change in the cap gains tax rate have anything but a neglible impact on investor behavior . . .

Perhaps one day, some semblance of rationality will work its way back into economics.

Barry Ritholtz

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