CHAPTER FIVE

Capital Gains Are the Elusive Jackpot That Drive Innovation

The prospect of capital gains provides an especially important incentive; it is the big jackpot that attracts entrepreneurial vigor.

—Robert L. Bartley, The Seven Fat Years

The Dallas Cowboys are the most valuable team in the National Football League.¹ Thanks to sponsorship and premium seating revenues of two hundred million dollars per year, along with a share of league television, licensing, and merchandizing revenues, the team can claim a net worth of over three billion dollars.

The owner, Jerry Jones, bought the Cowboys in February 1989 for $149 million. He quickly fired the legendary coach Tom Landry and hired his former University of Arkansas teammate Jimmy Johnson. Jones and Johnson proved an excellent team, at first anyway. By 1993 the Cowboys were Super Bowl champions. They won it again in 1994, and a third time in 1996, with Barry Switzer as head coach.

Jones’s stupendous success may appear easy in hindsight, and his purchase of the team back in 1989 may seem a no-brainer. The NFL’s annual revenues of ten billion dollars put it on par with several countries. The league gets five billion dollars a year for the rights to televise its games. It earns one to two billion dollars annually in sponsorships from companies like PepsiCo, two billion from ticket sales, and reportedly a billion more from licensing and merchandizing sales.2 Considering what a cash machine the NFL is and what the Cowboys earn separately from their state-of-the-art AT&T Stadium, Jones would have been crazy not to buy the team when it was put up for sale in the late 1980s.

But just as the present is a flawed predictor of the future (remember when Mark McGwire, Tiger Woods, and Lance Armstrong were among the most popular athletes—and people—in the world?), it is often worthless in trying to understand the past. Jones’s investment bankers at Salomon Brothers tried to convince him not to buy the Cowboys, warning him that he was risking his net worth on a lousy investment.

Jones bought the team from H. R. “Bum” Bright, who sold it because the Cowboys were a money loser. In 1988 the team had posted a 3–13 record and lost nine million dollars. More than ninety of the luxury suites in their old home, Texas Stadium, were empty, only one game in ’88 had sold out, and attendance had declined 25 percent from 1984 to 1988.³

Roger Staubach famously quarterbacked “America’s Team” to two Super Bowl wins in the 1970s, and by 1988 he was overseeing a successful commercial real estate firm. His name and sterling reputation would have opened up almost any rich man’s door if he had tried to raise the capital to buy the team he knew better than almost anyone. But when the Cowboys’ long-time president Tex Schramm encouraged him to assemble a group to buy the team, Staubach “soon dropped the project when he found little interest.”4 The fact is, the NFL and the Dallas Cowboys of 1988 were a far cry from the gold mine they are today. Jones risked his fortune on a business that was unattractive to the smart money three decades ago.

So what was Jones’s initial reward for the risks he took? When he flew down to Austin to dismiss Landry, the livid coach told him, “You could have saved your gas.”⁵ Landry was venerated in Dallas. When Jones fired him, people started calling the Arkansan “Jethro” after Jethro Bodine, the nouveau riche rube of Beverly Hillbillies fame. Others called him “The Eighth Blunder of the World,” and many cars in Dallas sported bumper stickers reading “Money Can’t Buy Class, Mr. Jones,” and “The Dallas Cowboys . . . From One Bum to Another.”⁶

Maybe Landry had a point and Jones could have handled the transition more gracefully. But the fruits of Jones’s life’s work were wrapped up in an acquisition that everyone thought was a bad idea. Jones famously promised that he would have a role in every aspect of the organization: “I intend to have an understanding of socks and jocks. . . .”⁷ But what he didn’t mention—probably because of his unshakeable belief in himself and the restless energy that characterizes entrepreneurs—was the price of failure. The players and employees would still have their wages, but he could have ended up with a lot less.

Jones’s story is useful in explaining the capital gains tax, the tax we impose on successful investments. If Jones sold the team today, he would owe the federal government several hundred million dollars for having revived a franchise that was losing both games and revenue when he bought it. In other words, the capital gains tax is the penalty the government places on his success. Jones did more than risk his capital. Like most entrepreneurs, he put in ungodly hours fixing what he had bought. His biographer, Jim Dent, describes him as “an adrenaline-charged blur of a man. He can accomplish more on two hours of sleep than most men can on a full night.”8 And after all that risk and work, the federal government will help itself to a substantial portion of the investment’s upside.

A funny thing about the debate over the capital gains tax is that its supporters call the fruits of investment “unearned income.” There is no mention of the work that went into acquiring that capital in the first place. Though Jones earned the bulk of his pre-Cowboys fortune in the energy business, he started at the age of nine, “greet[ing] customers at the family supermarket back in Arkansas. In college he sold shoes from the trunk of his car.” Dent notes that Jones “has sold virtually everything under the sun, from chickens to real estate.”⁹

The policy of taxing “unearned income” ignores the effort that goes into creating the wealth that can eventually become investment in commercial ventures like the Cowboys. Worse, it suggests that people like Jones passively invest their earnings with no regard to fixing what is broken—not that there’s anything wrong with that, as I will explain in the next chapter. Every dollar of Jones’s substantial fortune was earned, and he used those earnings to purchase and revitalize an unattractive property called the Dallas Cowboys. But what if Jones had faced a capital gains tax rate of 98 percent?

That’s silly, you say. No politician would penalize investment success at such a confiscatory rate. Yet Great Britain taxed what the Rolling Stones’ guitarist Keith Richards referred to as “so-called unearned income” at a rate of 98 percent in the 1970s. Richards concluded, reasonably enough, “that’s the same as being told to leave the country.”10 Judging from Britain’s feeble economic growth in the ’70s, lots of other entrepreneurially minded subjects got the message and did just that.

Successful entrepreneurs are not rich because starting a business is easy or safe. They’re rich because starting a business is difficult, and investing in a new business is the very definition of uncertainty. Capital gains taxes make it much more difficult for entrepreneurs to attract the capital they need. With a capital gains tax of 98 percent, you’d be a fool to invest in a new business no matter how promising it seemed.

The U.S. economy experienced problems similar to Great Britain’s in the 1970s. The capital gains rate charged on investment returns then was 50 percent, and, unsurprisingly, investment in future business concepts nearly ground to a halt. The cost of investment was high (and the dollar was falling—a problem I’ll discuss in detail later), and there was an average of only twenty-eight initial public offerings a year from 1974 to 1978.

A reduction of the capital gains rate to 25 percent in 1978 caused the number of IPOs to soar. The number increased to 103 in 1979, and in 1986, 953 companies were taken public.¹¹ Incentives, such as lowering the penalty on investment returns, clearly matter.

The capital gains rates that prevailed in the United States and Great Britain in the 1970s would have substantially increased Jerry Jones’s risk in buying the Cowboys. Why would he buy a losing team and spend the money and effort necessary to turn it around if Uncle Sam was going to take half his profit if he ever sold it?

Here lies another contradiction within the conceit of “unearned income.” With a capital gains tax of 50 to 98 percent, Jerry Jones probably wouldn’t have bought the Cowboys. But if he had traveled the world and bought expensive cars instead, the tax system would have smiled on his behavior. A life of consumption rather than work and investment would have lowered his tax bill. Putting his life’s earnings into the Cowboys, by contrast, would have generated a tax bill in the hundreds of millions of dollars, assuming he eventually sold the team.

But do entrepreneurs really worry about tax rates when they put money to work? Can’t we assume that Steve Jobs and Jeff Bezos were so focused on revolutionizing computers, tablets, phones, and the way we shop for them that no amount of taxation would have deterred them? And when Jerry Jones bought the Dallas Cowboys, he declared, “I always wanted to be in the football business.”12

Maybe so, but there are no entrepreneurs without capital. Someone somewhere must delay consumption in favor of savings and investment so that entrepreneurs can work their magic. Remember, people have choices when it comes to their money. At present, the tax on capital gains is 20 percent, but investors also have the option of buying municipal bonds issued by the cities in which they live. “Munis” have low volatility, so selling them usually produces small capital gains or losses. Even better, income from munis is exempt from both federal and state tax. If you think about it, you can see why IPOs practically disappeared in the ’70s. Faced with high risk and high taxes if they invest in a business, savers will protect their wealth in largely tax-free investments like municipal bonds.

Steve Jobs and Jeff Bezos had to raise capital to start Apple and Amazon. More to the point, some investors delayed consumption in order to put their capital into Apple and Amazon. But if the capital gains rate had been 98 percent, à la Great Britain in the ’70s, you probably wouldn’t have a pocket-sized computer phone or the ability to shop for numerous goods online today.

Jerry Jones, of course, didn’t have to raise capital to buy the Cowboys. He used his own money, so maybe the capital gains tax wouldn’t have fazed him. Nevertheless, wealth is a function of savings and investment, so Jones made use of previous capital gains when he invested in his NFL team. And remember, he said he had always wanted to be in the football business. If Jones had faced 1970s-level capital gains taxes, the football business might have been far less appealing.

The NFL’s collective success is largely the fruit of its ambitious owners’ willingness to spend on front office workers, coaches, and players. It is often said that the genius of the NFL is its league-wide parity. Year after year, once down-on-their-luck teams become Super Bowl contenders. But if capital gains taxation promised a near-zero return for success on the field, owners would have little incentive to expend capital on the coaches or quarterbacks who represent the difference between mediocrity and hoisting the Lombardi Trophy. More realistically, the NFL of today would not exist if the capital gains rate were at levels that prevailed not too long ago. Why should anyone take risks to improve his organization if politicians will consume the majority of the rewards that might result?

Fortunately, capital gains taxes are much lower than in the 1970s. And for men like Jerry Jones, wealth is about “keeping score,” so they continue to take big risks. Indeed, Jones’s success taught other owners how to enhance the value of their teams. The Cowboys haven’t won a Super Bowl since 1996, but Jones paved the way for businessmen like Robert Kraft, who bought the New England Patriots for $172 million in 1996 and took on an enormous amount of debt in the process.13 Kraft’s Patriots have reached the Super Bowl five times, winning three of them, and today they’re regarded as the model franchise in the NFL. Under Kraft, the value of the Patriots has soared to $2.6 billion.14 All the other NFL teams have benefitted from Jones’s and Kraft’s success.

Buying an NFL team was a big risk for Kraft—risk that was a source of friction with his late wife, Myra. She “went cuckoo on me when I got back” from buying the team, he acknowledges.¹⁵ He probably wouldn’t have purchased the Patriots if the capital gains rates of the ’70s were in place in 1996. Without the possibility of turning his purchase into something far more valuable, Kraft had no reason to take on so much debt, and incur the wrath of his wife.

Some might respond that neither Kraft nor Jones intends to sell his team. That’s not the point. If the capital gains rate had been 98 percent, or even 50 percent, Jones probably wouldn’t have built the wealth he needed to buy the Cowboys, and Kraft would have been unable to attract the financing for his purchase. The NFL is a better and more prosperous league thanks to the arrival of owners like Kraft and Jones, but it is important to remember that other business sectors are no different. Investors have choices and make decisions that are shaped by incentives.

Failure is how we evolve economically. It provides information to entrepreneurs and frees up capital for more productive uses. But the possibility of failure makes investing risky. Investors who might risk their capital in the private sector know they might lose it all, and they face a 20 percent tax on whatever return they do get on their investment. Those same investors have the option of buying government bonds, and though the returns are small, they’re reliable and, in the case of municipal bonds, tax-free.

Now, government performs certain functions that no one else can perform and which are necessary for a free economy—providing security and the rule of law, for example—but it produces no wealth. Our tax code, nevertheless, puts entrepreneurs at an enormous disadvantage when they compete with the government for investors.

What have we lost with a tax code that gives government consumption preferential treatment over an investment in the next Steve Jobs? It’s impossible to quantify, but since economic progress is the result of matching talent and ideas with capital in the private sector, it’s horrifying to imagine what we’re losing—cancer cures, advances in communication that would make the iPhone seem dull, and better transportation.

In a sane world politicians would abolish the capital gains tax altogether and raise the tax on income from government bonds. It won’t happen any time soon, because politicians live to tax and borrow from our productivity in order to spend it. But make no mistake about the reduced standard of living that is the cost of squandering the people’s money.