Wednesday, July 27, 2005

Bubbles as taxes?

Investment bubbles leave significant social value when they burst: we have a super-cheap Internet backbone because of over-investment in fiber capacity. Many investors lost their shirts, as a result of lemming-like investment decisions, fraud (when a company like WorldCom is doing so well, its competitors persuade themselves that there must be a pony, and keep throwing good money after bad), irrational optimism, and confirmation bias.

This is not a new phenomenon. Stock investors lost huge amounts during the build-out of the railroads in the 19th Century.

Large private losses which result in common social assets substitute for taxes. Investors are in effect handing over their money to the commonwealth. Since large investors are more likely to be rich than poor, large losses are more likely to fall on the rich than the poor. This "tax" is therefore nicely progressive.

Questions: What is the relative size of investment losses vs. ordinary taxes for large net worth individuals in the course of a bust cycle? (One would have to include the use of losses to reduce taxes on other income in the calculation.) Do rich people lose more than ordinary ones in a bust? (Wealthy folk have portfolios, but the rest of us have retirement accounts; since there are more of us, we may bear as heavy a burden in aggregate.) Do government losses when bubbles burst off-set the social gain of losses incurred by investors? (Governments often invest alongside the private sector, or provide significant tax incentives.)

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