Another way to think about Capital Gains Taxes

Capital gains tax rates should be commensurate with the holding period of an investment.

Differentiating “long-term” and “short-term” capital gains for tax purposes based on a one year holding period is a rule that has outlived its usefulness. This tax should be designed to encourage long-term investment — and implementing such a system is possible today.

For some background, capital gains are earnings realized when an investor sells a capital asset at a higher price than their “cost basis,” often their original purchase price. These gains are taxed by the IRS for two principal reasons: First, capital gains taxes are levied to to collect government revenue. Second, they exist to be at least somewhat “progressive,” since the capital gains taxes are disproportionately paid by wealthier households that have the opportunity to invest. (source)

Presently, capital gains are subdivided into two categories based on the length of time an investor held the asset. There are “long-term” capital gains for holdings greater than one year and “short-term” capital gains that apply to holdings one year or less. Generally, short-term capital gains are taxed at ordinary tax rates, whereas long-term capital gains are taxed at a preferential rate. Presumably, this distinction is designed to encourage long-term investment that could drive economic growth.

However, I think this one year cutoff is completely arbitrary. Consider one investor who sells their position in a stock after 364 days and another who sells two days later after, holding it for 366 days. The tax treatment of these nearly identical holdings is completely different. I believe there is a solution that better encourages long-term investment.

To visualize this idea, here’s a comparison of current treatment and what my idea could look like:

Capital Gains Tax Visualized
Capital Gains Tax Visualized

The current system is a step function, dropping significantly for investors who hold assets for more than one year. My proposal entails gradually reducing the tax rate to better incentivize long-term investment.

Politicians often talk about capital gains tax rate with respect to income but nobody seems to have questioned tax rates with respect to holding period. They argue about the position on the y-axis, (See 2020 Democratic Candidates’ Proposals) but I have yet to hear a candidate call into question the tax treatment of different investment holding periods. Duration of investment matters, and tax policy should reflect that.

There are a few reasons that I believe in incentivizing long holding periods via the tax code would be advantageous to investors:

First, encouraging long-term investment would reduce emphasis on quarterly reporting, potentially giving companies leeway to grow with less pressure to “hit quarterly figures.” Resources are wasted because companies engage in “earnings management” every quarter to impress Wall Street for their own private gain. This would potentially be reduced if investors had greater incentives to hold onto their positions longer, thereby reducing the importance of any given quarter.

Second, this proposal would benefit retail investors who already have a long holding period. Institutions that engage in short-term trading would subsidize those with a longer investment horizon, making for a more democratic marketplace.

Third, but perhaps most importantly, longer duration investment could lower the cost of capital for firms. A lower cost of capital means a lower “hurdle rate” for companies’ investments in capital projects, which are meaningful undertakings that drive economic growth. This assumption is based on the capital asset pricing model (CAPM) that suggests lower volatility with respect to the market (as measured by beta) leads to a lower cost of equity capital. My hypothesis is that if investors held shares for a longer timeframe, volatility would be dampened. Companies issue stock frequently through many means: employee stock options, convertible securities, or subsequent equity offerings. Simply put, the cost of equity matters to companies and encouraging long-term investment could reduce that cost.

Also, the implementation of this proposal would be relatively simple since brokerages and transfer agents already record buy and sell data for each tax lot electronically. With trading done predominately online, knowing one’s precise holding period is now possible.

This proposal is not flawless. Encouraging longer-term investing could create a “lock-in” effect, discouraging flows away from unproductive investments. It also could disrupt the “efficiency” of equities markets. Price discovery is an important characteristic of the stock market.

Consider high frequency trading (HFT) shops like Virtu Financial or Citadel that engage in arbitrage between markets, for example. These firms technically make for a more efficient market, although some consider this to be “scalping” from retail investors. The book Flash Boys by Michael Lewis discusses HFTs and a new exchange called IEX that seeks to level the playing field among investors. My belief is that if these firms have a sufficiently robust business model, they would still remain profitable, even if taxed at a higher rate for their very short-term capital gains. It’s important to make a distinction between a financial transactions tax and a capital gains tax for short-term participants: my proposal would only tax net gains, instead imposing barriers on trading that arguably discourage price discovery and liquidity in the market. Further analysis would need to be done to make my proposal consistent with corporate tax legislation and rules like IRC section 475(f), but I believe that discussion is beyond the scope of this post.

Balancing efficiency and equity is an important factor in tax policy. Warren Buffet has famously said, “Our favorite holding period is forever.” (CNBC) Nearly all investors, companies, and the marketplace itself would benefit from incentivizing longer-term holding. We ought to encourage that in our taxation of capital gains.

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