Promoting Long-Term Investment and a Solution to Shorting

by: Jake Huneycutt
The New Mentality

In the “olden days”, buying stock was not a simple matter for the average American, who had no connection to the financial community. You found a broker, paid him what now seems like an exorbitant fee, and he set in motion the process to purchase the stock for you. It was a pain and it wasn’t cheap so you invested for the long-term; otherwise, your profits were so thoroughly decimated by fees that you’d never earn decent returns.

It’s amazing how much technology can change things. During the tech boom of the 1990s, online brokerages like E-Trade (NASDAQ:ETFC) were popping up all over the place. You could trade relatively cheaply and easily even if you weren’t a Wall Street big shot. As more online brokers entered the sphere, prices for trades dropped further and further. Nowadays, you can find brokerages like Scottrade offering $7 per trade online. While reducing fees for average investors has been a fantastic development that has allowed your middle-class Joes to keep more of their hard-earned money, the ease of trading has also caused some societal changes. A new mentality has begun to develop.

As we entered into an age where low fees were the norm and trades could be consummated with a mere click, “daytraders,” began to pop up. This was really only the tip of the iceberg, really, as even those “Wall Street hotshots” began to think about trading in a radically different way in the new age. Stocks slowly morphed from a form of ownership of real companies and into a form of abstract profit-making. Of course, there was always some sense of the abstract in the market, but it got to the point where a majority of the market participants arguably were ignoring the fundamentals behind the companies they were investing in. Investing became about psychology and little more.

Is it possible to have a fruitful and productive business environment when those who contribute the capital have no incentive to care about the long-term viability of the enterprises they invest in? Shouldn’t the goal be to encourage strong businesses that create real value for all of American society rather than temporary wealth for a few? I don’t think most Americans would disagree with that assessment. However, our tax code doesn’t clearly reflect these priorities any more.

Promoting Long-Term Ownership

Income and capital gains tax rates have shifted numerous times over the past century. Sometimes it seems like these shifts have come on nothing more than whims, while at other times, specific policy goals were being targeted. Yet, it still feels like the government has not necessarily adjusted to the new reality.

I often hear of proposals for lowering the capital gains taxes. I’m not opposed to this on one level, but on another level, I ask myself what purpose does it serve and what American societal interests does it advance? But I agree --- capital gains taxes should be lowered --- and raised.

Of course, lowering and raising capital gains taxes should serve a function. America should be promoting ownership. You can’t create real societal wealth by promoting abstract derivative investments that have only a tangential relationship to reality. Nor can you promote building real wealth by allowing people to profit off of doing nothing. You can create societal wealth, however, by building strong businesses that provide vital services to Americans and the rest of the world. Those types of businesses would be more likely to thrive in an environment where long-term ownership is promoted.

While I feel that a lot of dramatic changes need to be made to the American taxation system to promote real wealth rather than the illusions of wealth we have been promoting over the past few decades, amending the capital gains tax system would be a great start. I am quite flexible on the details of these proposals --- I merely suggest them as starting points for discussions, but here are a few ideas on how to promote long-term ownership in companies

Incentivizing Long-Term Investments

To create incentives for long-term ownership, Congress should think about lowering the capital gains tax for investors with a long-term horizon. It should also eliminate the capital gains tax completely for investors with a very long-term orientation. While in one sense, it may seem counterproductive to eliminate CG taxes altogether on certain investments, I see no reason not to given the fact that investors are already taxed once at the “corporate tax” level. My proposals on this front:

(1) Create a 3-year Capital Gains (NASDAQ:CG) tax bracket that is taxed at the 15%.

(2) Create a 7-year Capital Gains (CG) tax bracket that is taxed at 5%.

(3) Create a 10-year Capital Gains (CG) tax bracket that is taxed at 0%.
Proposal #1 probably seems confusing given that the current Long-Term Capital Gains (LTCG) rate is 15%. However, that will be explained below. The only thing that might be problematic about all these CG tax brackets would be offsetting gains with losses. That might be remedied by classifying all of these tax brackets as “LTCGs” and allowing all LTCG losses to offset gains in the highest tax bracket available. For instance, if an investor made a (NYSE:A) $10,000 profit on a 4-year investment, (NYSE:B) a $6,000 loss on an 8-year investment, and (NYSE:C) a $5,000 gain on a 15-year investment, they would pay $0 tax on investment C, and they could offset their $10,000 profit on investment A with the $6,000 loss on investment B to claim a $4,000 gain taxed at 15%.
Creating Disincentives for Short-Term Speculation

The next step should be to create huge disincentives to short-term speculation. Additionally, while I believe a 1- to 3- year investment time frame does not qualify as “speculation” by any measure, it also does not necessarily serve the end goal of creating high-value enterprises. My proposals are as follows:

(1) Tax all CGs on investments held for less than two weeks at 95%.

(2) Tax all CGs on investments held for less than three months, but greater than two weeks, at 70%.

(3) Tax all CGs on investments held for less than one year, but greater than three months, at 50%.

(4) Tax all CGs on investments held for less than three years, but greater than one year, at 25%.

Proposal #4 would obviously be the most controversial of the bunch. I’m not necessarily opposed to leaving that tax as is, but I think a slight increase in it could help offset lost revenue from the new LTCG brackets; plus, it would help create an additional incentive for greater long-term investing.
While I believe that extreme short-term investing provides no real value to our society, I do believe that medium-term investment (1- to 3- years) is very useful. But it doesn’t necessarily promote building vibrant businesses either, so I see a slight increase as justified (so long as we incentivize longer-term investments).

As far as offsetting goes, I’d define the 1- to 3- year CGs as “Medium-Term Capital Gains” (MTCGs) and all the rest as Short-Term Capital Gains (STCGs) that would have to be offset only at the lowest (hence, least advantageous) tax rate.

Dividend Treatment

My proposal for dividend treatment is that they should be taxed at the same rate as the medium-term capital gains rate, but that investors who qualify for one of the long-term CG brackets to claim a lower rate based on their time horizon.

Gains from Short Selling

I’ve heard arguments both ways on short-selling. On one hand, short-selling does not really promote strong businesses that create enduring value. On the other hand, short-selling does serve the vital function of incentivizing investors who look for cracks in companies’ earnings and reported financials.

My thought here is that Congress should tax all gains resulting from short selling activities at 50%, if they do not fall into a short-term CG bracket created above. This still rewards short-sellers, but it also recognizes that the value they create for American society is limited. Any short-selling losses that are medium-term or long-term in nature could be offset against MTCGs or LTCGs (if the taxpayer opts for this).
Debt and Its Tax Preferred Status

This moves into a little bit of a different direction, but with the effects of excessive leverage wrecking our entire economic system, it’s time to finally consider altering the tax treatment of debt financing. One reason why debt financing is often preferred by businesses over equity financing is the tax savings created from the interest deductions. While these deductions make sense on one level (since companies with debt accrue fixed interest charges that offset their income), they also encourage companies to take on debt rather than use equity to finance their operations.

A leverage test

Any proposal I give on this is going to be flawed in many regards, but just to get the discussion going, I would suggest trying to come up with some sort of leverage test to decide whether or not a business can claim the interest deduction. The question is, what do you base it on? Long-term debt (LTD) over equity? Liabilities over equity? The former seems problematic in that businesses might try to find clever ways to classify LTD as a current liability. The latter seems problematic in that businesses might be punished for no other reason than the payment standards in their industry.

Should we eliminate deductions for interest payments altogether? That seems like an overly harsh way to achieve the goal of promoting more equity financing. Perhaps we could just limit the deduction --- for example, companies could only claim half of their interest payments as a deduction. While I’d consider my other ideas “rough drafts”, I am unfortunately not even able to get the ball rolling very much on this issue. However, it does seem like we should do something to stop actively promoting debt financing.

What are Your Ideas?

None of my proposals are meant to be rigid, inflexible policy ideas. In fact, I imagine there are many downsides to these proposals. This article was merely meant to ‘get the ball rolling’ and the bigger point is that we need to start thinking about ways to stop promoting speculative investment vehicles that create no real economic value to the American economy and start promoting healthy, viable businesses that will create true wealth for America.

One thing I dislike about American politics right now is that there is so little productive discussion on public policy; it’s all very simplistic pro- and anti- garbage. We need to move away from that and begin discussing issues on a pragmatic level again. On that note, I’m interested to hear others’ thoughts on how to achieve the objectives discussed in this article via tax policy or even via other policies.