Finding the Dream Economy
July 19, 2005

Finding the Dream Economy

Close your eyes.

Conjure the Dream Economy.

In this economy, everyone is able to borrow money. I'm not talking about a little bit of money. You can borrow lots of it. Better still, you can borrow it for long periods of time. And, if you played your cards right, you only have to pay interest on the amount borrowed. You wouldn't have to deal with any of those pesky principal payments.

Hiring workers in the Dream Economy is a snap. And it doesn't cost much because so many workers are available. There are no payroll taxes, no benefits, and no messy paperwork. There is no workmen's compensation to pay. Finally, you just hire people as you need them. Many are hired for no more than a day. It's as easy as driving to a few well known spots. You pick workers as you need them.

Many will work for even less. All you have to do is take out your checkbook when it's time to pay. Then you pause. You ask if they would prefer cash.

They do.

So you ask the cash price.

Finally, there are no taxes to pay when you sell your product. We're not talking about low taxes. We're talking about no taxes. Not a dime. You keep every penny of the money you make in your business.

Of course, there might be some limit on how much you can make. So let's say you're married: Would you be inconvenienced if you had to start paying taxes after you had made $500,000 in two years? If you were single, would you regard it as excessive taxation if you could make $250,000 in two years before you had to think about taxes?

My guess is that everyone and his brother would like to work and live in the Dream Economy.

So, where do you have to go?

Believe it or not, you don't have to go to some place that ranks higher on the Index of Economic Freedom than the United States.

The Dream Economy is part of America. It's in your backyard, literally. Your admission is easy. Own a house, something most people want to do anyway.

While the word "bubble" is now inseparable from discussions of real estate, most observers have ignored a simple fact. Congress created the Dream Economy in 1997 when they liberalized the rules for capital gains in home ownership. The new rules allow couples to realize up to $500,000 in gains on the sale of a house, tax-free, every two years. Prior to 1997 you could only defer gains if you bought a more expensive house. After 1997, homeownership became a tax-free zone and gains became tax-free income.

At the same time, no tax, no benefit labor was available on a local corner (usually near a Home Depot) and lenders were creating ever more attractive loan packages. It helps if you speak Spanish. Together, the three elements created the Dream Economy.

What does all this mean?

Some of what we're seeing isn't a bubble at all. It's what economists call "tax capitalization" at work. Investors pay more for a dollar of tax-free municipal bond yield than they pay for a dollar of taxable bond yield because they don't have to pay taxes on the income from tax-free bonds.

When Congress lowered tax rates on stock dividends and capital gains, it was a boon to the stock market. If Congress eliminated the current 15 percent tax on dividends and capital gains, we could expect stock prices to rise by about 18 percent as stocks were priced up to reflect their tax-free status.   And areas with high real estate taxes tend to have depressed prices while areas with low real estate taxes tend to have high prices.

If we have a bubble in real estate prices, part of is simple tax capitalization. The dangerous part is the rise in prices because people are giddy about tax-free income.

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