U.S. TAX POLICY FAVORS HIGH-RISK INVESTING
It is clear that during many of the past 50 years, risk-free investments such as Treasury bonds offered real after-tax returns that were either negative or in the low single digits for high-bracket investors. (For example, a 5 percent nominal return in a 40 percent tax bracket with 3 percent inflation is a zero percent real return.) Under these conditions, a safety-minded investor cannot create much value, and during long periods she may slowly see value erode.
But a high-risk investor can actually do a fairly good job of approximating total tax avoidance. If she invests in a basket of fairly high risk, poorly correlated securities, in an average year she will have some gains and some losses, but more probably a net gain. (Common stocks have averaged about 11 percent annual appreciation over the past 70 years.) She can sell all of her losers to establish tax losses and sell winners that generate an equal amount of gains. The tax-free proceeds of these sales can pay her living expenses, and any balance can be reinvested in new stocks. Until she runs out of losses, she will pay no tax. In effect, she can use risk—here viewed as a dispersion of returns—to create a tax shield, whereas we have shown why an investor who opts for a risk-free return has no such shield.
With a tax structure that favors value-creating high-risk investing and rather heavily penalizes more conservative investment patterns, it is no surprise that the United States leads the world in business innovation. The good news is that we seem, for the moment, to be better than the other guy. However, viewed through the lens of total value, the U.S. tax system is a large encumbrance when compared to an ideal system designed to maximize value creation. This is the bad news. But it is also good news, in a sense: There is room for improvement. As we get smarter, we’ll get better.