§14. Capital Gain not Income

The most interesting and valuable result of applying these bookkeeping principles is that thereby we automatically separate capital from income, two things which are so often confused and in so many ways. It is not uncommon for economic students to make the mistake of including capital gains as income. Capital gains, as already implied, are merely capitalization of future income. They are never present income. Therefore a true meticulous accounting, item by item, of the income, or of the services and disservices, rendered by any specified group of capital items will infallibly grind out this truth. It will never confuse capital gain in that capital group with income realized from that group. This is true whether our capital group and its income are so extended as to include enjoyment income (positive and negative) as the final net income, or whether our specific group is so restricted as to leave plowing or money payments as the uncancelled fringe.9 We shall always find that only the income actually detached from, or given off for en Edition: current; Page: [26] joyment by, that group, as in cutting coupons from a bond, will result from the summation of the accountant, who will never record as income the increase or decrease in the capital itself.

A bond price, for example, will grow with accrued interest between two coupon cuttings. That growth in its value is not income but increase of capital. Only when the coupon is detached does the bond render, or give off, a service, and so yield income. The income consists in the event of such off-giving, the yielding or separation, to use the language of the United States Supreme Court. If the coupon thus given off is reinvested in another bond, that event is outgo, and offsets the simultaneous income realized from the first bond. There is then no net income from the group but only growth of capital. If the final large payment of the principal is commonly thought of not as income (which it is if not reinvested) but as capital it is because it is usually and normally so reinvested.

Likewise, if my savings bank account gains by compound interest, there is no income but only an accretion of capital. If we adopt the fiction that the bank teller hands over that accretion at any moment to me through his window, we must also adopt the fiction that it is simultaneously handed back by me through the same window. If the first event is income, the second is outgo. If it passes both ways, or does not pass at all, there can be no net income resulting. This is good bookkeeping and sound economics. There is no escape from such mathematical conclusions. By no hocus pocus can we have our cake and eat it too. This is as impossible as perpetual motion, and fundamentally as absurd. The absurdity is especially evident when the cause of an increase or decrease in the capital value of a bond or investment Edition: current; Page: [27] is not due to any change in the expected income at all but comes through a change in the rate of interest. Consols and rentes fluctuate in value every day with every change in the money market. Yet the income they actually yield flows on at the same rate. Merely the capital value is found sometimes on a 3 per cent basis and sometimes on a 4 per cent basis. A rise in the market is a capital gain, but it is not income. Income may be invested and thus transformed into capital; or capital may be spent and so transformed into income. In the first case, as we have seen, capital accumulates; in the second case, capital is diminished. In the first case the man is living inside his money income; in the second case he is living beyond his money income.

If Henry Ford receives $100,000,000 in dividends but reinvests all but $50,000, then his real income is only $50,000,10 even if his money income is $100,000,000. And if, during the year of rebuilding his factories to make his new car, he received no dividends and yet spent $40,000 in that year for living expenses and all other satisfactions, then his real income was this $40,000 even if his money income that year was zero.

Thus the income enjoyed in any year is radically different from the ups and downs of one's capital value in that year—whether this is caused by savings or the opposite, or by changes in the rate of interest or by so-called chance.

We may in our bookkeeping add our savings to our real income and call the sum total gain. For my part, I Edition: current; Page: [28] prefer not to call it income. For the two parts of this total—enjoyed income and accumulation of capital or capitalized future enjoyments—are unlike. The only argument for adding them together is that the recipient could use the savings as income and still keep his capital unchanged. Yes, he could, but he didn't, otherwise there would be no savings! One part is income, and the other is capital gain.

This distinction between the real income, actually enjoyed, and the accretion or accrual of capital value, that is, the capitalization of future enjoyments, is not only in general vital, but vital to the understanding of this book.11

We cannot understand the theory of interest so long as we play fast and loose with the concepts of capital and income. And enjoyment income, which plays the central role in interest theory, is never savings or increase of capital.