Promoting Long-Term Investment and a Solution to Shorting

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 (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 (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 (A) $10,000 profit on a 4-year investment, (B) a $6,000 loss on an 8-year investment, and (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.

Comments

[dantes:]

This would, if ever even considered by serious people, kill the market. There would be no capital market left. Stocks would fall of a cliff and there would be no use trying to issue shares to a public stock market. What the author fails to understand is that stock markets have always had very short term "speculators" and that those are vital for the liquidity and functioning of a market. In the old days these short term speculators were limited to an inside club at the floor of the exchange and they took advantage of everybody else and made huge profits at the expense of normal investors. Technology and other developments have leveled the playing field so that it is now possible for almost anybody to be part of that vital short term speculative activity that lubricates markets. This has come at the expense of , for example , NYSE specialist who have in effect gone out of business. Your proposal would be great for them as they would once more be in the driving seat and take the common man to the cleaners.

Mar 08 09:06 AM

[H.J. Huneycutt:]

Dantes,

I can't think of anything that would kill people's desire to invest in the market more than a 0% capital gains tax. You're absolutely correct; no one would ever want to invest in such an environment and no one would be willing to start a business with a guarantee that they would pay lesser taxes than they do now.

</sarcasm>

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As far as this article goes, I wish SA would quit re-titling everything. I have proposed no "solutions to shorting". I think short-selling is a good thing. In fact, after writing this, I've somewhat reverted on that one particular issue and believe that gains from short-sells should simply be taxed as regular income (so long as they meet a minimum time threshold).

In particular, what leads me to this position is the work of some short sellers in snuffing out real scams. Citron Research's recent work on Apollo (APOL) is something that definitely should be encouraged.


However, unlike the poster above, I see very little benefit in promoting market volatility. Make people invest for the long-haul so they are forced to evaluate their decisions. Rampant speculation provides no added value to the markets and the attempt to claim that wealth disparities are somehow cured by speculation is nearly absurd --- especially considering the fact that the two time periods in recent American history with the grossest disparities of wealth also JUST HAPPEN to be two of the worst periods for rampant speculation. Imagine that.

Mar 08 11:34 AM

[dantes:]

Mr Huneycutt, I agree with you that rampant speculation has very few good effects. However I don't agree at all with your understanding of financial markets. If your proposals would be implemented there would be no functional markets for your long term investors to buy and sell shares. Bid-offer spreads would be many per cent with very small volumes. The only way to ensure functional markets would be to go back to the old model of a limited insiders club with different rules, such as the old NYSE specialist system, and let them provide liquidity in the markets. Once upon a time markets effectively worked they way you want them to work, and then NYSE specialist franchises were handed down from father to son as they were far to lucrative to let outsiders in on the action. But no market has ever been able to function without liquidity providers. Your suggestion is utopia, plain and simple.

Mar 08 03:11 PM

[dantes:]

Also I must make the following very important points:

1. Long term investors only invest if they know that there always will be a short term price when they want to get out of their investment. If they don't know that, they would not dare in the first place.

2. Restricting short term speculators will not decrease volatility, it will increase it, mainly due to less liquidity and smaller number of players in the market.

3. The markets today have a problem of too little liquidity and that is partly why markets are falling. No one dares to own things when they don't know if there will be a market for it tomorrow. We need to find solutions that increase liquidity.

Mar 08 03:53 PM

[Brad Castro:]

Reducing longer term capital gains would probably be enough to encourage longer term investing without imposing draconian tax rates on short term trading which, I would agree with dantes, would kill the market.

You either believe in free markets or you don't. Although I have a long term investing mindset myself (honestly, I do), I'm puzzled why the author finds short term trading to be so threatening that he would, in effect, propose abolishing it by taxing it out of existence.

The market volatility over the last 18 months or so hasn't been the result of short term traders. On the contrary, it was caused by extreme overleveraging of stupid loans. In particular, the volatility of Oct/Nov 2008 was a result of forced asset liquidations, not market speculators.

Even though I trade options, I consider myself a long term investor (I employ conservative option trading strategies that mimic value investing). For me, long term investing (with a little help from my options) is more profitable and much easier than short term investing. Biased as I am, I think more people should invest like me. But I certainly wouldn't want to outlaw those who don't invest like me.

Mar 09 07:48 AM

[H.J. Huneycutt:]

To be honest, I find both of your concerns to be highly exaggerated and both of you miss the point in the proposals. Check out capital gains rates during most of the 20th Century. We actually used to have a system that more closely resembled the one I'm proposing. Yet, the markets didn't die and wither away.

My point is not that capital gains tax rates have led to the collapse of the market. My point is that our current system encourages speculation and does not encourage adding real, lasting economic value to the economy. You've got to create incentives to do that and currently, there are very few; many people can make more money speculating (which provides no real value to the economy).

What both of you ignore is a realistic cost-benefit analysis. Certainly, under my proposal, hardly anyone is going to play something for less than a 2-week time frame. But no one is going to shy away from buying something at a deep discount even if they have a short-term timeframe. After all, I'd much rather take a huge profit and be taxed 50% on it, than take no profit at all. I've only proposed absurd tax rates on extremely short time frames. Anything over 3 months, I can see as semi-useful.

To suggest that the markets would die is simply misguided. Equities have a long history and it's not as if people always had 2-week time-frames for their investments. When you are buying a stock, you are buying a business and so long as that business is turning out profits, there will be demand. This fact is lost on most investors nowadays.

In fact, your concerns seem to be guided by a belief that there is no fundamental value to equity; which is precisely my issue right now. The speculative nature of the markets has essentially moved people into a psychological investment mode where they don't actually focus on the underlying business they are investing in. As such, how can you possibly expect businesses to operate with a long-term timeframe? It's all about NOW and not about the future.

The end of the markets? Hardly. These proposals would force people to invest differently. While it would certainly make the market more illiquid, it's goofy to suggest that would destroy the price for securities. Yes, demand would go down --- but so would supply.

Mar 09 10:50 AM