Tags: Elias | investment | overrated | unearned

Financial Investment Is Overrated

By    |   Friday, 28 Sep 2012 07:57 AM

Over the past 30 years, our financial industry has not added significant value to our society. Substantial portions of income generated by the financial community were essentially transferred from other sectors of the economy. The industry added significantly less wealth than most realize.

A recent paper by Robin Greenwood and David Scharfstein of Harvard Business School indicate the share of gross domestic product received by the U.S. financial industry rose by 60 percent from 1980 to 2007. In 1980, it was 4.9 percent of GDP — by 2007 it reached 7.9 percent of GDP. They suggest most of this “growth” was due to rising asset management fees and fees associated with residential mortgages. According to the Federal Reserve, the financial industry received more than 20 percent of all corporate profits, which excludes the tremendous level of compensation to its employees.

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During this time, the financial industry introduced too many high-risk products with too little capital reserves to protect against losses.

“[T]he enormous growth of asset management after 1997 was driven by high-fee alternative investments, with little direct evidence of much social benefit, and potentially large distortions in the allocation of talent,” according to Greenwood and Scharfstein.

This was exacerbated by the dismantling of the Glass-Steagall Banking Act of 1933 and the deregulation of derivative products in the late 1990s.

Greenwood and Scharfstein remind us that this distortion was facilitated by a biased tax code that encourages over-investment in real estate. Based on the Internal Revenue Service publication 936, the amount of mortgage interest that can be deducted is unlimited if the mortgage was obtained on or before Oct. 13, 1987. After this date, all mortgage interest may be deducted for loans of $1 million or less. At the current rate of roughly 4 percent, this translates to a maximum deduction of $40,000 in mortgage interest for a mortgage issued today.

Most investment in the equity and equity derivatives market is merely speculative side bets, with little direct investment in firms to create valuable products, increase employment and generate income. Currently, we provide preferential treatment to income generated this way. That is, most dividends and capital gains (unearned income) are subject to a maximum federal tax rate of 20 percent, 15 percentage points less than the 35 percent that applies to earned income.

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In addition, unearned income is not subject to the 15 percent payroll tax that funds Social Security and Medicare. Nearly half of the $13.8 trillion in personal income is exempt from these payroll taxes, because it is unearned and/or it exceeds the maximum taxable level of earned income ($110,000 annually).

It seems the societal benefits derived from investments that generate unearned income are exaggerated. As such, this income might not deserve the highly preferential treatment it currently receives.

(Revised Oct. 8, 2012)

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Elias
Over the past 30 years, our financial industry has not added significant value to our society. Substantial portions of income generated by the financial community were essentially transferred from other sectors of the economy.
Elias,investment,overrated,unearned
485
2012-57-28
Friday, 28 Sep 2012 07:57 AM
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