Increasing the deduction for investment loss - good or bad idea?

Great Debates
1

The Bush administration is considering an idea proposed by Charles Schwab to increase the deduction for investment losses from the current $3000 to perhaps as much as $20,000 per year. Cite.

In principle it seems like a sound idea:

  • The deduction hasn’t been raised in over 20 years, and, as Mr. Schwab put it, $3000 is indeed an insult, .

  • It would help many folks who’ve gotten soaked by the market this year to recover some of thier losses.
    Personally, I’ve gotten killed this year, so $20k off my taxes sounds like a fine idea. But I do have mixed feelings about this proposal:

  • Would it cause an already shakey market to fall further as folks finally abandon bad investments because they can recover something, anything, through a tax break? And as the market falls, would more investors bail, etc etc? Are we really helping the investing climate, or throwing blood into the bear feeding pit?

  • It would cost a zillion dollars. More than half of all Americans own(ed) stocks, so many, many folks would use the tax break. Can we as a nation, with huge deficits at this moment, afford it?

If I’ve missed a previous discussion on this topic, apologies.

2

Tax cuts can be judged by a number of criteria:

  1. Are they regressive? (That is, do they benefit higher income brackets over lower income brackets).
    A: Yes, in this case.

  2. Do they stimulate the economy? To the extent that the cuts flow to higher income groups, they will tend to benefit those with a lower “marginal propensity to consume”. Result: less bang for the buck, as it were.

  3. Increasing this deduction will encourage the taking of “paper losses” during boom times (heck, during any time). My tax advice: Invest in 5 uncorrelated stocks. Some will go up. Some will go down. Swap out of the ones that go down into other stocks with similar risk characteristics. Take the tax loss. Result: Free $ from the IRS, for the clever.

  4. For the reasons outlined in #3, the capital loss allowance is set at a low level, intentionally. (Note though that there are no absolute limits on gross capital losses: it is the net capital loss that is limited to $3000.)

  5. Anything that encourages more stock trading (and this modification sure would) will help Charles Schwab.

  6. If investors sell some of their shares, but use the proceeds to buy more shares, I would expect that the market would not be affected too much. But I may be wrong.

  7. I don’t know how expensive this proposal would be. I await the analysis by Citizens for Tax Justice, the CBO, etc.

  8. In general, budget deficits during recessions are not a bad thing: higher government spending stimulates the economy; lower taxes raise consumption. It is the medium and long-run budget projections that are a concern. Once the economy is running at or near full capacity, budget deficits tend to redirect savings away from private investment. Alas, the budgetary outlook for the 2000-2010 period declined sharply following the multi-trillion dollar tax cut passed in 2001.

  9. In a few years, lots of people will want the Alternative Minimum Tax rules changed. This won’t be cheap to fix.

  10. Most post 2002 GWB tax cuts go to the top 1% income group.

3

flowbark, thanks for the thoughts. Some counter-thoughts:

Hmmm, I tend to disagree that this is all that regressive a proposal. Suppose the deduction is indeed $20k. This is chickenfeed to Gates or Buffet (or W., for that matter), but a relatively attainable loss for a middle-income earner who’s been stuffing a 401k for a decade and didn’t shift assets out of stocks in the last 12-24 months. Obviously a 20-year-old working at Jiffy-Lube doesn’t fit that demographic, so your point is somewhat well taken, but someone losing $20k in the market these days isn’t necessarily a rich investor. Ask any of the ex-Enron employees who’ve lost thier retirement. :frowning:

Regarding point #3: I don’t see how the deduction lets someone game the system, if that’s what you were implying. If you sell a losing stock but make money overall in your investments, no deduction. If you lose money overall, you get back a portion of your investments, not the whole thing, from the IRS, if you have other income to offset it. You’ve still lost money, so there would seem to be a major incentive to use this deduction as a last resort, not as a an investing strategy. If I’m misunderstanding your point, apologies.

Re: #5 - Yes, the proposal was obviously self-serving. Which doesn’t make it a bad idea, although a healthy amount of skepticism is indeed warranted.

Re: #6 - that’s entirely the crux of my concern – there’s so much disenchantment with the market right now, I’m afraid folks would sell stocks for the paper loss and put the money in anything but stocks, causing a crash or at least a prolonged depression of stock prices. Which wouldn’t benefit anyone.

Re: #8 - Certainly, reasonable deficits are cause for concern, not panic. But the budget is starting to resemble a trainwreck lately, and I’d rather not place more iron bars in front of the train.

Re: #9 - Yep, AMT. The lurking giant in the corner. This is a taxpayer revolt in the making.

Re: #10 - Agreed. And this is relevent how?

4

Obviously a 20-year-old working at Jiffy-Lube doesn’t fit that demographic, so your point is somewhat well taken, but someone losing $20k in the market these days isn’t necessarily a rich investor.

Yes, but a rich investor is positioned to manipulate her holdings such that she takes a 20K capital loss every year even when her net worth is rising.

Let me work through an example. Say you invest in the S&P 500. It goes up by 10% in a given year. So far so good.

Now divide the S&P 500 into 5 sectors. Invest your funds ($500,000, say (ha!)) in 5 sectoral index funds. Three go up by 10%, two go down by 10%.

For the 2 that go down, take a $20,000 capital loss ($10,000 each) and swap into an actively managed sectoral fund.

Merely by making some straightforward tax maneuvers, this investor has scored a long term capital loss of $20000 (=$4000 tax benefit, annually). This sort of behavior should not be encouraged, as it does nothing to increase societal wealth, but merely shifts the tax burden away from investors that have the means to pull off stunts like this. (It also reduces public wealth by wastefully directing resources towards pointless stock trades).

It’s not clear to me whether the $20,000 allowance would apply to short term capital gains. If they did, they could generate over $7000 of tax benefits annually for the upper income groups.

Points 3&4 were key. The rest were “context” (read: rhetoric :slight_smile: ). On point 8, if there was some sort of temporary spending that could be arranged (eg build a few extra Predator weapons, handicap ramps, whatever), that did not involve long-run obligations, those would be a good thing.

How regressive this plan would be in practice is of course an empirical matter.

Finally, if you want to help the working poor, raise the earned income tax credit. If you want to help the newly unemployed, overhaul the unemployment insurance program. If you want to help the lower middle class, manipulate the bottom tax brackets.

Personally, I think the recent drop in the stock market has provided a useful education for many investors. But then again, I’m a cold-hearted capitalist. :wink: As for Enron, et al, I would say the key issue is improving corporate governance and not distracting the public with these bogus quick fixes. (Sorry about those losses though, sq.)

5

Great, I screwed up my math. “Three go up 23%, two decline by 10%.” etc. etc.

6

flowbark, We seem to have completely different reads on how the capital loss deduction works. My understanding is that you can deduct investment losses where a ‘gain’ or ‘loss’ is the result of all of your investments combined.

If my reading is correct, then in your example there would be no 20k deduction because overall the investor made money. I don’t know which of us is right, and obviously the difference is crucial re: regressivity.

If your reading is correct, then I certainly agree with you that increasing the deduction is probably a bad idea, or at best more regressive than it should be. If my reading is correct, it becomes much less so (although, as I type this, I wonder if, to make this deduction sustainable in the current budget climate, there should be some sort of cap based on income).

I suspect my reading is correct because that’s how I understand the current $3k deduction works (and regular income taxes on short-term investments gains, for that matter). Shall we google? :slight_smile:

All good points. Personally, I’d like to see payroll taxes dropped quite a ways. They’re a regressive tax that directly affects all those groups you list, and was in large part responsible for the surplus. Now we’re on the verge of frittering it to the rich by shifting those taxes from Social Security et. al. to fund tax cuts and spending, which is a monstrous injustice to the folks who see such a bite out of thier paychecks every pay period.

7

I believe flowbark is correct. Only realized gains and losses go into tax calculations. (i.e., when the investor sells the stock.) In flowbark’s example, the investor realized only the losses. Of course, the investor would eventually have to realize the gains when he wanted to spend that money.

Thank you flowbark for answering the question I didn’t even ask yet: Why should there be any limitation on recognizing investment losses immediately? Your example shows why.

Given that there needs to be a limit, I do think it should be raised in the interest of fairness. One ought to get the tax deduction from a loss eventually. At $3000 per year, many investors won’t live to take all their losses.

8

Ah! Thank you, december. I’d missed that crucial point in flowbark’s example. Of course you only take a gain or loss when the instrument is sold. :smack:

OK, that having been said, I still don’t see the problem (‘regressivity’) with the above example: the investor is recouping a portion of some losses. No sane investor would intentionally choose loosing money over not loosing money, so the deduction doesn’t encourage paper losses as ideal investment behavior. So why is a deduction for the loss (yes, a transitory one) a bad thing?

9

Losses are full tax deductable provided they are matched by capital gains.

By postponing gains and accelerating losses, you can cut your tax bill even when your net worth is rising.

Go back to my example. The proposal would allow 2 people with nearly identical portfolios to pay significantly different amounts of taxes merely because one of them divided his index fund among 5 sectoral funds while the other didn’t. This is a violation of “horizontal equity” in tax policy parlance.

december: You do know about capital loss carryover, right? The $3000 cap is a per year cap. You are allowed to take $12,000 of losses over 4 years, for example. Just checking.

I gotta admit though, there might be rationale for raising it to, oh, $5000 per year. But I’d like to see some expert analysis first.

Since we’re playing with ideas, one could in theory have a tax system where unrealized capital gains are taxed: in that case, I would think that there shouldn’t be any limit on capital losses. OTOH, it would be a royal pain to fill out tax forms under such a scheme.

10

But this is already true (and has been for 20+ years) with the $3k deduction. Nothing new here.

And I’d like to see analysis of the costs – there’s already a $3k deduction, so there should be plenty of data on how it’s used and what the cost is to the tax coffers, so scaling that to $5k or whatever should be straightforward.

Jeez, I can’t even imagine how something like that could be administered. If your gains are unrealized, you pay tax on the paper profits; then the stock plunges and you would get back all those taxes. Hmmm, the words ‘screw that’ come to mind. :slight_smile:

11

Sure. I might have explicitly mentioned it, though. My point was that for investors who’ve lost, larger amounts, it could take an awfully long time to get the full deduction at only $3000/year.

Of course, they might be able to take the deduction more quickly, if they had realized capital gains to offset.

12

I’m glad we’re all on the same page, as it were.

squeegee:
Let’s reset the capital loss allowance at zero $, hypothetically.

  1. You are correct that such a situation would still allow for substantial horizontal inequity, since the practice of realizing capital losses while you’re net worth is rising can still be exercised.

  2. This problem increases as the capital loss allowance increases.

  3. Figuring out the effects of increasing the capital loss allowance from $3000 to $20,000 would be tricky, as the latter would stimulate additional tax planning. ($3000 gives $600 of tax benefits at a 20% rate while $20,000 gives a full $4000 of tax benefits). So the estimate would have some error.

  4. Now that the costs of selling stock are relatively low (provided you work with a discount brokerage), taxing unrealized capital gains is more plausible. I share your sentiments, however.

  5. December: Ya. I suspect in practice, realized capital gains should become available over upcoming years, provided you kept a diversified portfolio. (Of course, many make the mistake of not doing the latter; alternatively, many expose themselves to profit sharing plans that force them into a nondiversified portfolio). Then there are extended bear markets to consider.

  6. For completeness: Those operating a small business can declare “ordinary gains/losses” which don’t have the $3000 cap that “capital gains/losses” have.

13

Ha ha, with Hollywood doing accountring tricks to such an extent that so that a movie that made $500 million for them would be reported as a loss, this law would be a huge windfall for them.

14

Correct me if I’m wrong, but this proposal has no effect on the vast majority of 401(k) holders because those losses (even if realized) are tax-deferred anyway. Capital gains (or losses) accrued by 401(k) plans are not taxed (or credited) until withdrawal, so if you haven’t retired yet the fact that your 401(k) “lost” $4000 this year has no tax implications this year. And anyone who has a substantial 401(k) who has now retired will be realizing gains as they make withdrawals, even accounting for the rather significant fallbacks of the market of late.

15

:smack: !! : of course the losses from a 401k are deferred, so the deduction doesn’t do squat for working stiffs w/ retirement accounts. (Or is KellyM missing something? Anyone?)

OK, with that bubble having been burst, the shine is starting to really wear off the Schwab proposal for me (in spite of my big personal stake in a greater deduction). If we can’t help the Enron-screwed et. al., why bother?

16

Yeah, this stuff is irrelevant for all retirement plans. I thought you knew that sq. (My fault though, I should have been clearer to begin with. Anyway, you can see why I talked about regressivity now, notwithstanding the fact that lots of people have at least a little dough in mutual funds (outside of 401K, IRA, etc.)

It’s also irrelevant for Hollywood: those are ordinary gains/ losses, not capital gains/losses, as defined by the tax code. (At least I think so.)