I have been thinking about investment quite a bit lately. After losing $30,000 in three weeks around a month ago, I decided to pull out of the market for a while. I will remain out until the hysteria over corporate responsibility shakes out and the prospects for the economy improve in an unequivocal sense.

Of course, there is a way to change investor psychology that would help offset these factors almost overnight.

Government loves to collect taxes. Here is a section of a report from the Congressional Budget Office that speaks to likely causes for the decline in income tax receipts; the full report is here :

The Usual Suspects

The first likely factor is capital gains income. Realizations of capital gains are not part of national income or GDP. But they are taxable income to individuals and corporations. Consequently, they can grow more rapidly or fall more precipitously than national income, resulting in changes in revenue proportionately greater or smaller than changes in overall economic activity. CBO's analysis indicates that rapid growth of capital gains realizations explains about 30 percent of the growth in individual income tax receipts relative to GDP from 1995 to 1999, so they may be playing a major role in the decline in FY 2002 receipts.

When projecting gains receipts in its January 2002 and March 2002 baselines, CBO already had good estimates of the calendar year 2001 level of the stock market and GDP--big influences on the level of gains realizations that would help determine final tax liability payments in April 2002. As a result, the March baseline, in comparison to the baseline of January 2001, projected a 23 percent decline in realizations and a $27 billion decrease in gains receipts. But because realizations are so volatile, the decline may be greater than econometric analyses of past behavior would suggest. Distributions of capital gains from mutual funds were down in calendar year 2001--reportedly by about 80 percent. Total gains realizations differ from those in mutual funds: stocks are the principal component of mutual funds, but only about half of total taxable gains come from stocks, with the rest coming from other capital assets, such as real estate. As a consequence, total gains would likely have fallen less than gains in mutual funds. Thus, while realizations almost certainly explain some of the FY 2002 shortfall, they very likely do not account for all of it.

A second likely factor is the slower growth of very high incomes in comparison to that of overall income. Those incomes are taxed at the highest rates and produce a disproportionate amount of income tax revenues. From 1995 to 1999, very rapid growth in very high incomes accounted for about 16 percent of the growth in the revenues in excess of GDP. A reversal could very well reduce receipts by a significant amount.
In addition, enough changes occurred this year--including the tax cut, the recession, and the drop in the stock market--to have altered the usual division of tax liability between withholding and estimated payments on the one hand and final payments and refunds on the other. In the 2001 tax year, the ratio of refunds to withholding departed from its previous, relatively stable, pattern. The larger-than-usual role played by final payments and refunds may mean that taxpayers were surprised by economic developments in 2001 and continued to withhold higher-than-necessary amounts. That overwithholding could have been simply the consequence of lower capital gains realizations; but it could also have been because earnings weakened over the course of calendar year 2001, and taxpayers paid withholding at a higher marginal rate than would have been the case had their earnings been steady throughout. In either case, the overwithholding suggests that shortfalls in receipts from two different years could have been bunched into a single year's collections, making the reduction look more ominous than it really was.

Noticeably absent from this list of likely causes are stock options and bonuses, because bonuses are a form of wage income, and most options are included in wage income measures when exercised. They also reduce taxable corporate profits at the same time that they increase taxable wage income. Nevertheless, options and bonuses may play a role in the distributional effect just described. To the extent that they accrue primarily to people with very high income, their rise and fall can affect the receipts-to-GDP ratio. The lower the proportion of income coming from bonuses and options of high-income individuals, the lower the receipts from a given level of wages and salaries. And because options income is typically withheld below the top marginal tax rate, it can disproportionately affect April payments when taxpayers settle up on their liability. Some early evidence suggests that options income may have fallen by 50 percent in calendar year 2001, in contrast to the 30 percent decline built into CBO's projections.

I believe that the drop in capital gains income is due to factors that include 1) lower receipts from the sales of stock, mutual funds, businesses, etc. and 2) a decline in dollars invested in these instruments.

One factor that could help increase investor interest in putting more capital to work is equal treatment of capital gains and capital losses in income tax law. If your investment earns a dollar today, that dollar is fully taxable less applicable deductions. However, under current law, if your investment loses money, you cannot fully deduct those losses on a dollar for dollar basis. The government allows you to write off a maximum of $3,000 per year until your loss is deducted completely. If you lost a little, this may only take a year or so. In my case, and I believe in the case of many people nearing retirement age, the losses cannot be deducted in the investor’s remaining lifetime.

This is unfair, and stacks the deck against those willing to put capital at risk.