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How Democrats Should Talk About Capital Gains Taxes

No one has ever proposed a policy that differentiates between actual formation of a business, savings and speculation/investment. This is the key difference Democrats want to make in their proposals, yet have failed to do.
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Capital gains and dividend taxes usually cause a large number of problems for Democrats. On one hand, these taxes disproportionately benefit the top income tax brackets. According to the Tax Policy Center 90% of qualifying capital gains and 66.5% qualifying dividends go to incomes over $100,000. Democrats understandably want these individuals to pay their fair share of taxes. However, capital gains and dividend taxes are also key elements of capital formation - essentially starting a business -- and long-term savings. These are two activities the policy should promote and not discourage.

However, no one has ever proposed a policy that differentiates between actual formation of a business, savings and speculation/investment. This is the key difference Democrats want to make in their proposals, yet have failed to do. Below are several proposals that make this distinction and would therefore provide an adequate starting point for a discussion of capital gains and dividend taxes.

Capital Formation

It's important that tax policy favor the development of business ventures. These breeds new life into the economy and always hold out the possibility of creating the "next big thing" which has huge benefits for the economy as a whole. Therefore, tax policy should be advantageous to new companies, specifically the process of forming a new company and "going public." The tax code already favors the private formation of a company. Therefore, nothing needs to change here.

However, there is a blanket capital gains tax policy that needs to change to favor IPOs. Here's a short version of how a company goes public -- issues shares to be sold on the securities markets for the first time. Company X enlists an investment bank/brokerage firm to do the paperwork - comply with all of the SEC regulations. In addition, the investment bank/brokerage firm will usually form a "syndicate" which is a group of firms that all sell the IPO to their respective customers. Most of the money raised goes to Company X, with a cut given to the investment bank/brokerage firms for their work. Because the company will use the money for its own investment, the activity of going public should have a tax advantage.

Trading Profits

The profession of trading -- buying and selling securities with the intention of making a profit -- has been around for longer than a century. Traders seek to "buy low and sell high", or to make momentum plays in the market where they ride a security's price up or down. This process was originally written about by Richard Schabacker, William Gann and H.M. Gartley and is currently called "swing trading". This type of transaction has two key elements that are different from an IPO.

1.) One trader purchases a security from another trader. In other words, the money from the transaction will not go to a company with the express purpose of investment as in the case of the IPO mentioned above.

2.) Most of these types of investments seek to take advantage of market movements that last less than 1 year. This is one of the key points in all of the writings mentioned above.

Because these types of transaction are not about capital formation but are instead about creating income, they should be taxed as ordinary income.

However, transactions that last longer than one year are usually an investment, leading to a discussion of savings.

Savings

Saving -- especially for retirement -- is a crucial area to focus on from a policy perspective. According to the Bureau of Economic Analysis' Personal Income figures, the US savings rate has been negative for the last few years. While the method of calculating this figure has come under fire for a variety of reasons, other studies -- most noticeably from the FDIC -- have confirmed this trend. In a recent speech, FDIC Chairman Sheila C. Bair lamented the loss of the US savings culture. In addition, this study from the FDIC in 2006 concluded:

While there is no definitive standard for how much a person needs for retirement, many baby boomers appear to have a net worth insufficient to meet basic retirement needs, according to some guidelines. In 2004, the median net worth for families headed by baby boomers between the ages of 45 and 54 was $144,700. However, these data are somewhat difficult to interpret, as wealth holdings in the United States are skewed toward the top 10 percent of families (see Chart 3, next page). The median family net worth was $1,700 for the lowest 25 percent of U.S. households and $43,600 for those in the 25th to 49th percentile. In contrast, those in the 75th to 89th percentile had median family net worth of $506,800, while the figure for those in the top 10 percent was $1.4 million.

So savings -- most notably for retirement -- should receive a tax advantaged rate to encourage savings. Retirement plans already grow at a tax deferred rate, meaning they are already sheltered from taxes. However, the current capital gains structure put in place does not provide a strong enough incentive to induce additional savings as evidenced by the low national savings rate. Therefore, some additional policy initiatives appear to be needed.

First, a return for a preferential capital gains rate for longer-term investments is in order. This jibes with the section above that discussed trading gains. While shorter trades are usually about individual traders looking for income, longer-term investments are typically made because the perceived rate of return is higher than a savings rate. Therefore, investments that last over a year should receive a lower capital gains rate to encourage long-term planning and savings.

Additionally, the amount an individual can contribute to any retirement plan needs to increase substantially. The amount an individual can contribute to his retirement account should be at least $10,000/year. Increasing the amount an individual can contribute to a retirement account will greatly increase the incentive to save.

Conclusion

1.) Short-term trading -- usually defined as holding securities for less than a year - is almost always about a trader getting income. Therefore, these trades should be taxed as ordinary income. 2.) Longer-term investments -- those over a year -- are usually about beating the then prevailing savings rate. Therefore, these should be taxed at a lower rate to encourage savings. 3.) The amount an individual can contribute to a retirement plan should be increased in a big way.

For economic Commentary and Analysis, go to the Bonddad Blog.

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