Clinton's cap gains tax proposal vs status quo

Great Debates
1

Clinton has proposed changing the capital gains tax rate structure from having a 1-year short/long-term cutoff between 39.6% and 23.8%* to a 6-year stepped rate that holds steady for the first two years and decreases after years two through 6. See this bar chart.

*Oversimplified. E.g. I left out the 3.8% surtax for the highest earners. Ordinary/qualified dividends are treated similarly to short/long-term gains, respectively. Lower-income taxpayers have different rates. A full explanation can be found here: Capital gains tax in the United States - Wikipedia

**This thread is about the effects of the proposed change vs the current tax rates, especially with respect to the stated, intended effects, described below.
This thread is not about whether capital gains should be taxed as ordinary income or not at all, about double taxation of profits, etc.

My understanding of Clinton’s reasons are as follows:

“Quarterly capitalism” is bad. Businesses care too much about short-term wall-street performance over longer term performance, which is more important for the economy as a whole. We see lots of stock buy-backs and dividend payments instead of reinvestment, which would be better for the U.S. Activist investors try to force changes, divestitures, etc. to make a quick buck. This rate adjustment would encourage longer-term investment and would free management from short-term performance pressure.

What will this new rate structure do? Most capital gains are realized before 6 years:


0-1 12%
1-2 35%
2-3  6%
3-4  5%
4-5  4%
5-6  3%
6+  35%

CBO estimates that holdings would shift to 36% taxed at the highest rate in the first two years (even split between first and second years), and 49% held for 6+ years. I haven’t checked the methodology. But assuming that’s all correct, we should expect some elasticity. It’s not a huge change. Is it enough to affect management behavior? I don’t know. A lot of shareholders are tax-exempt, but I don’t know if they’re the sorts who push for short-termist behavior.

One of the WSJ opinion pieces below says the proposal will cause harm:

The Moneyweek piece suggests that stopping dividend payments to short-term investors might have a more profound effect. I’m not sure how that would be legislated.

I generally do not like laws with sharp cutoffs, be it time or income, so this gradual approach appeals to me simply for that reason. I think that whether the proposed change will have a large effect or not is dependent in large part on who the short-termists are. If they’re big tax-exempt organizations or people with retirement accounts, I don’t think this will do much. But my guess is those sorts of shareholders are more in it for the long-haul.

Background reading and others’ opinions:

http://www.wsj.com/articles/clinton-to-push-revamp-of-capital-gains-tax-rates-1437365173
http://www.wsj.com/articles/what-would-clintons-capital-gains-tax-mean-for-you-1437761670
http://www.wsj.com/articles/hillarys-capital-lock-in-1437948796

http://www.forbes.com/sites/dougschoen/2015/07/14/hillary-clinton-rolls-out-her-economic-platform/2/

2

Any encouragement of long-term holding harms the market’s liquidity. The current 1-year cutoff is not that harmful, IMO. Clinton’s proposal will cause serious harm.

IMO, when market liquidity is harmed, the share prices will be negatively affected. If that’s Clinton’s goal - well, the mission will be accomplished.

3

The WSJ, I’m guessing, started off with, “it’s a Clinton proposal. Let’s figure out what’s wrong with it.”

I don’t think their reasoning makes sense. Why did the big gorilla get all the facebook stock upon IPO? And encouraging people to hold onto stocks (if they invest in individual stocks) is a good thing. But if a little guy wants to be a venture capitalist, they’re probably smartest to start their own business. If they’re just looking for good investments, mutual funds are a less risky way to go. So even if the WSJ is correct, discouraging Joe Everyman from buying individual stocks isn’t the end of the world.

So I don’t see it as a bad thing at all. It encourages capital investment, by lowering the rates long term, but it also discourages panicky sells, which has always been more small-time investor behavior anyway.

4

I think your chart is screwed up. ETA: Oh, sorry. I thought that was supposed to be the rate structure. You’re saying that is the percentage realized after “x” years.

5

Yeah sorry I ripped that from the taxfoundation link. They have a few more plots there. Might be better to read that over my clumsy summary.

6

Well, THAT I don’t believe, Terr’s point that it’s going to lead to lesser involvements in the market. There’s currently so much liquidity in the markets that share prices will likely be unaffected by that sort of pressure. It’ll have some effect, of course, but if it wasn’t negligible I’d eat my cat.

As to changing the capital gains rate? I’ve always flipped back and forth on it (sort of like the national sales tax). Currently there are incentives that reward the investor class with lower rates for being in the market for more than one year. This indicates that a decision has been made that holding for the long term has some advantage for society. Stepping it out for six years, especially gradually, doesn’t lead me to believe that there’d be overall damage to tax revenues or to investor interest in the market.

The fact is there’s just no where else to go for most of the deep pocket investors. Not mom and pop with their IRA but the big pension plans and endowments. Most of them are forbidden from investing in Bonds that aren’t investment grade and that means returns in the sub-3% range. If they want to make gains at all it has to be in equities.

I could see this leading to investors laddering their stock purchases. So instead of buying $1MM shares of MSFT - for example - they’d buy $200K every year for five years to stagger when their money is escaping capital gains. It’s not unlike what occurs now in the bond market to hedge interest rate risk.

I’d also be interested in seeing an exemption - just spitballing here, I haven’t thought it through - for the first, say, $100,000 in investment income. So dividends, capital gains, bond interest and so forth would be exempt up to that point. That would allow grandma and grandpa - who live off their investment income - to avoid taxation completely while still providing capital gains revenue for government.

There’s a strong argument to be made that making long-term capital gains rates lower than labor-based income taxes is an artificial subsidy that goes preferentially to those least in need of such breaks. The argument that it rewards individuals for investing in the growing economy has always rung hollow to me. Most investors aren’t individuals and don’t take that sort of equation into account. The inverse - that in punishes those who derive their income through working - certainly seems true on the face of it.

7

:smiley: One of them says “it won’t do anything” and the other says “it will do bad things.” I’m not sure it can do both.

8

I think the idea is that you incentivize the holding of shares so people will “take that sort of equation into account” without realizing they are doing so. Volition isn’t required to make the system work.

But I do agree that it’s a subsidy of investing over working. I’d just tax everything the same way and index any investment gains to inflation.

9

I’d be all for it. I write software for day- and position-traders, and my user base would explode.

10

Oh, I also wanted to mention - upon review - that I have known a great many people locked into investments because of capital gains. I’m thinking of five or six clients would have held some shares of various equities for decades and now refuse to sell because of the potential capital gains hit. Even the lower rate becomes a formidable obstacle when the amount of cap gains is in the millions.

Instead they hold it because they know that the cost basis resets upon inheritance. Example: Ma and Pa Kent bought General Mills back on 6/1/1972. They sell grain to them, they like the firm. Fine.

GIS 1972 Amount: $25,000 (The Kent’s do pretty well having never had to buy plows and tractors and such. No one knows why.)
GIS 2015 Amount: $2.67MM (Now updated with real info from Morningstar!)
Capital gains: $2.645M
Cap gains taxation: $396,750
“Screw that”, says Pa. "We’ll just hold it and live on the 3% dividend.

Ma and Pa Kent die. “Everyone I can do? All those powers? And I couldn’t even save them…” Very sad.

Clark returns from Metropolis to oversee final expenses and such. The Kent’s broker chats with him and he realizes that he has $2.67MM worth of General Mills. Woot!

Cost Basis prior to death: $25,000
Cost Basis on inheritance: $2.67MM

There is therefore NO capital gains if he sells out quickly and buys a bunch of charcoal briquets and gets squeezing for Lois. Good on him.

But in this case there’s two potential adverse incentives. First, the Kent’s felt a disincentive to sell - make liquid - their GIS shares because of the long growth period of their shares. Second, Clark has no incentive to hold for any length because of the reset button on the cost basis because of his inheritance.

Combine that with the estate tax exemption of $5.4MM in 2015 and Clark is feeling pretty good about himself at the moment. Provided Monsanto doesn’t offer him more for his inherited land that $2.7MM he’s in good, tax-free shape. Kansas might get him for something - I don’t know KS estate laws - but otherwise he’s good. He’s good.

Edited to add: I ran into my branch to get some stuff and thought I’d real world this. Changes: Morningstar will only go back to 1972 for General Mills. That changed the time frame and the ending result to $2.67MM. Three takeaways. First, the Kents did better than we thought. Good for them. Second: Am I good at estimating or what? I was within 10% off the top of my head with a 45 year projection. Third, General Mills destroyed the S&P over the time frame (S&P topped at $1.7MM). Take THAT index fund advocates!

11

I expect it will decrease liquidity, but I don’t know by how much. And I don’t know how to quantify the current marginal benefit of liquidity. We may be in a regime where it matters a great deal or not at all.

Going to the quoted Facebook example, would we expect prices to rise because IPO investors wouldn’t make as many shares available to folks who want them?

12

I don’t see this idea getting through the US Congress without 20,000 pages of exemptions that only apply to the richest 1% of tax-payers, thus reducing if not eliminating their tax liability.

No, this won’t do what it intends to do and Jonathan Chance’s cat is safe for the time being.

13

That’s the beauty of being a presidential candidate. You get to propose all kinds of stuff that you KNOW will never actually become reality.

14

Why, he could afford to buy some property way up north, maybe a fishing cabin or lodge or something.

15

Just someplace to go, get some “alone-time”.

16

That’s a super idea!

17

Isn’t it the case that when anything in an economic system is changed, someone is “harmed,” directly or indirectly? So doesn’t a claim that “doing x will have a negative effect on [usually some subset of the economic spectrum]” have to be judged in an overall sense, and not in some kind of contrived “do no harm” sense?

18

Because of the way the underwriting process for an IPO works.

19

Not necessarily, but it’s a good bet, Amateur Barbarian.

Adjusting an economic system assumes that economics is not a zero-sum game. That is, by setting incentives properly the net total of wealth will increase.

Example:

If there were two widgets in the world and they were distributed so that two players each had one you could change the incentives in a zero-sum game so the distribution was instead 2-0. Someone wins, someone loses.

In a market based economic system one can hope to avoid that outcome. With growth you can start here:

1-1

And using incentives end up with:

3-2

Or whatever. Growth may not increase the wealth of all equally but every player gains something out of the process. Improper, or skewed incentives could lead us to the current system where wealth is becoming increasingly concentrated. So instead of 1-1 we end up with:

20-2

Both sides have gained but the right side of the equation is harboring some resentment over the fact that the left side has gained so much more. Whether the right side is correct or not depends on one’s politics and economic theory. But that there is a skewed distribution is indisputable.

Would someone lose - or gain less - if the capital gains rate is changed? Certainly. But who exactly that would be is a complex calculation. Day traders and short-term investors would be hammered - but they tend to be under the current system as it stands. Those who hold investments beyond one year but less than six would see an increased tax rate. How many people that is I’m not at all certain. I’m sure someone knows.

20

It seems to me this plan would introduce liquidity risk into the capital markets. I don’t see where this will lead to higher rewards (saith the blind). As such I believe this will shift capital out of the markets where there’s a minimum of liquidity risk into markets where liquidity risk already exists. For example if one pays too high a price for moving their stocks around every other year, then they might as well buy into real estate.