Clinton’s Capital Gains Tax Proposal: Why Worry About Capitalism Today, When You Can Worry About It In A Few Years?

Just about any person who is good at something will emphasize that you have to practice. If you really want to do something, go after it. Pursue your dreams.  Isn’t that what makes America the land of opportunity?  To borrow from the old Shakespearean adage: Some are born great, some achieve greatness, and some have greatness thrust upon them.

There are a few exceptions in virtually every walk of life, individuals who are blessed with such a degree of God-given talent that they can pursue their dreams seemingly without much effort. Take a great singer for example. If God gave you a voice that is 1 in 10 billion, your path to stardom is certainly made easier. Some are born great.

For the vast majority of us, success isn’t so easy. For example suppose your dream is to dance in a Broadway production. You don’t become a great dancer by taking dancing lessons haphazardly. You would never get anywhere if you decided to take lessons only when it was convenient. Suppose you started out practicing daily. If you have potential, it’s worth developing. However, maybe after a couple of months your enthusiasm wanes. Perhaps you realize the enormity of your goal and the small odds of being successful. This is the point that usually separates those who succeed from those who don’t. Success is never guaranteed, but the person who ultimately succeeds is willing to pay the price. Unlike success, failure can definitely be guaranteed. The person who decides to start practicing weekly, will ultimately end up practicing monthly, then perhaps sporadically. When auditions are announced, the person who lacked the commitment will almost certainly have no chance at being selected. Those few who pursued their dream without abandon…the ones who worked their hardest every day to accomplish their goal are far more likelier to be selected. Some achieve greatness.

Capitalism has always been the force behind everything in America. Yes, it has brought out the best and worst in people. However, capitalism works. Ultimately it works. Take non-renewable energy sources for example. Hillary Clinton would like to see the United States become entirely dependent on renewable resources by the middle of the next decade, mainly in the form of solar power. In reality, that will ultimately happen without government intervention. Once it becomes more profitable not to rely on non-renewable energy, the usage of coal and petroleum will eventually disappear. Further, there is no guarantee that the solution will even be solar energy. Perhaps an even better solution will be discovered by capitalists. Did the United States become the most powerful nation on Earth because its government has micromanaged how capitalism is practiced? No. Are some regulations needed to make capitalism more efficient? Sometimes, but those are exceptions, not the rule. Overall, American capitalism doesn’t need greatness thrust upon it. It’s already great. If you don’t believe that, then by all means pick a random country to live in. It’s highly doubtful your standard of living will be anywhere near what it is in America.

Hillary Clinton’s proposal to eliminate the beneficial capital means taxes will be available to investors aims to control capitalism.  It also betrays a fundamental lack of understanding of capitalism. If implemented, it would penalize investors in the top tax bracket by increasing the taxes on capital gains. It’s an artificial attempt to force investors to invest long-term. Currently, an investor in the top tax bracket would pay a 39.6% tax rate for sales of any investments held for less than 1 year. Any investments held for a year or longer are taxed at a favorable 20% rate. Under Clinton’s plan, a sliding scale would be introduced. The same 39.6% rate would still apply apply to investments held for less than a year. However, one would have to hold the investment for more than 6 years in order to pay the current 20% tax rate.

Under the new system, an investor would pay 39.6 for investments held between 1-2 years, 36% for 2-3 years, 32% for 3-4 years, 28% for 4-5 years, 24% for 5-6 years, and finally 20% for anything held longer than 6 years.

Theoretically, in a capitalist system, resources should be invested in the most profitable ventures. In a perfect world, this would happen immediately. As it stands, there is information asymmetry in the market. Everyone doesn’t know everything at the same time and everyone doesn’t have instantaneous knowledge as to which businesses are run the best and which businesses will provide the highest return on investment. It’s highly unlikely that on any given day, a company’s true value will not be reflected in its stock price. However, at some point it will be.

Ostensibly, the logic behind Clinton’s proposal is to curb “quarterly capitalism.” In the eyes of some leftists, it is bad for companies to focus on quarterly numbers. Clinton went as far as to say “American business needs to break free from the tyranny of today’s earnings report.” That is a truly terrifying statement. It is akin to saying that monthly bank statements are oppressive because if you are responsible with your money, it means you will have to take the time to do a bank reconciliation every month. Earnings reports are a GOOD thing. Going back to the original analogy: Capitalism isn’t something you worry about once a year or once every 5 years. Markets have to be scrutinized DAILY. Business opportunities need to be scrutinized DAILy. If not for quarterly reports, the stock market would be less efficient. How would stock prices be determined in-between annual reports? Guesswork?

In a capitalist system, the reality is that people should be happy to receive as much information as they possibly can.

Some companies even strive to report daily data. The stock market shouldn’t be based on gambling. If someone invests in Company Y only because it just reported high quarterly earnings, that would be a decision based on poor reasoning and would qualify as gambling. The decision to buy the stock should be based on an analysis of the company’s performance over numerous quarters and years as well as its potential moving forward. Stock prices are impacted based on quarterly earnings, but if a company or even an industry uses the same techniques to inflate or deflate income, such manipulation will become apparent over time. The more information available about a company or industry, the better. The market will adjust for quarterly manipulation. It’s a classic case of the boy who cried wolf. If you constantly lie, eventually no one will believe you. Instead, they will determine the extent of your consistent lies and adjust accordingly.

There are two ways to make money in the stock market. The first is to buy low and sell high. The second is to earn dividends. Sometime it’s a combination of both. Assuming there is no insider trading, there is no such thing as a ‘hot stock tip.’ The key to short term profits in the stock market is to identify stocks that are undervalued, buy the stock at the low price, wait for the market to adjust, and then sell the stock at a nice profit. Opportunities don’t last long in the stock market, so by the time the average person hears ‘a good stock tip’ most of, if not all the profits to be earned, have already been realized.

In some cases, the market quickly adjusts for undervalued stock and in other cases it doesn’t. For example, suppose through careful analysis, a person determines Company Y’s stock should be trading at $50 per share. However, the current market price for Company Y’s shares is $15. In such a case, it would make sense to buy as many shares of Company Y as possible, knowing there is a $35 profit to be made on each share. The crucial issue is when will the market adjust to reflect Company Y’s true worth. If such an adjustment occurs within a year, Clinton’s new tax plan would have no effect. If it takes more than a year, the impact would be considerable.

If one bought 300 shares of Company Y at the undervalued price of $15 per share and sold them at $50 per share, that would be a gain of $10,500. If one sells the shares within 6 months and is in the top tax bracket, they pay a tax of 39.6% for a net profit after taxes of $6,342. If however, they sell the shares at the same price, but instead of 6 months later, they sell them a year and a half later, their net gain after taxes would still be $6,342 under Clinton’s plan whereas under the current tax law it would be $8,400 (20% capital gains tax). How does taxing an investor an extra $2,058 promote the economy or increase jobs? It certainly increases revenue for the federal government, but wouldn’t it be wiser to let capitalist motivations dictate where the $2,058 be spent rather than leaving it up to the government to decide?

The goal of Clinton’s tax plan is to force investors to hold on to their investments longer, the assumption being that long-term investments ultimately yield better results in terms of both stock price and dividends. The argument is that short- term investments are often sold in order to earn a quick profit. In such a case, the investor has no interest in the long-term welfare of the company nor the dividends it pays. Therefore, if the tax law is adjusted to force a person to hold on to an investment longer, it will mean they have a vested interest in a corporation. If they have a vested interest in the corporation, then they will seek to implement reforms to make the business more responsible.

This is flawed logic because it presumes that the stock price will persist over time. In the example above, suppose that the price increases to $50 between years 2 and 3. Under current tax law, it would make sense to sell the investment and pay the 20% tax rate. Under Clinton’s plan the rate at that point would be 36%, which is a large enough tax increase to dissuade someone from immediately selling the investment. If the investor decides to hold the investment instead of selling it, there is no guarantee the price will remain at $50. What happens if the price drops to $30 or even $10? In such a scenario no one wins. The investor’s profit diminishes or even disappears all-together, and instead of the government receiving a 20% tax on a gain, it could end up receiving far less tax revenue in total or even zero tax revenue.

Zero tax revenue? That actually sounds like a pretty good idea. In fact a few of the Republican Presidential hopefuls have already suggested it. It has the virtue of letting events in the market play out as they normally would. It would also allow those with money to invest into new ventures (without severe tax penalties) which in turn would create new jobs. Of course, some will point out that there is no proof this actually happens, but is there any proof that it absolutely doesn’t happen?

Clinton also doesn’t seem to grasp the meaning of ‘long-term’ in the context of business. Under United States Accounting rules, a corporation would classify any asset that is to be held for either one year or the operating cycle of the business (whichever is longer) as ‘long-term.’ Is there any reason why an individual shouldn’t follow the same reasoning?

Also, it is highly unlikely that forcing people to hold investments longer than they wish will have any impact upon dividends, research and development, executive compensation, etc. According to Clinton, today’s earnings reports are tyrannical. Does this mean she believes they are too complex and inaccurate for normal investors to comprehend? If that is the case, how would such long-term investors possess the level of comprehension and sophistication it would take to create business reforms? To actually influence a corporation’s direction, a group of ‘reform-minded investors’ would have to possess the votes to oust the Board of Directors. This would be highly problematic in and of itself because a small group of like-minded investors may already own more than 50% of the voting shares and disregard everyone else. Even if that isn’t the case, most long-term investors are already satisfied with the status-quo. They are more likely than not to simply sign off on proxy requests for their votes than to participate in an organized effort to remove the Board of Directors. In most cases, if company management is performing poorly, the Board of Directors will remove them out of their own volition and self-interests. The Board of Directors is the only group that has the power to fire the CEO and other top-level executives. Removing a Board of Directors is very difficult to do. It doesn’t happen every day and Clinton’s plan isn’t likely to change that. (Note: According to U.S. accounting rules, if a corporation engages in research and development, said R&D must be deducted as an expense in the current year because it’s virtually impossible to allocate R&D to specific products. Consequently, R&D has the effect of reducing the net income a corporation reports. Clinton doesn’t address this disincentive to engage in R&D).

The fact is that most corporations have the ability to tweak income using different accounting approaches, all of which are completely legal as long as the rules are followed properly. Management has the authority to make estimates that impact the bottom line. Hopefully, their intent is to portray the company accurately in its financial reporting. Clinton sees quarterly reporting as a major problem. In reality, almost all corporations engage in some form of ‘income smoothing.’ All things being equal, shareholders prefer the stock price to stay constant and increase gradually. The last thing they want to see are wild price fluctuations which could be caused by an unforeseen loss in one year that will be made up for in the following year. If things are going to ‘even out’ in the end, corporations have an incentive to minimize both the good and the bad. The market isn’t always rational and will sometimes react to earnings or losses disproportionately in terms of the impact those events will actually have on the company’s future. Quarterly earnings numbers are just one method of ‘income smoothing’ to keep the stock price stable. It isn’t to be confused with illegal and dishonest manipulations that totally misrepresent the corporation and its future sustainability.

Lastly, it should be noted that stock transactions are not the only investments in relation to a corporation which are subject to capital gains taxes. Corporations also borrow money through corporate bond issues. If someone sells a bond they bought from the corporation before its maturity at a gain, they will have to pay capital gains tax. This then leads to a possible unintended consequence of Clinton’s proposal. Interest rates are a factor of both risk and time. Given Clinton’s new tax structure, there is far less incentive to sell an investment in bonds early if a capital gain situation exists. Also, take into consideration that corporations often build a ‘call’ feature into their bond issues. Suppose a corporation borrows money at 5%, which is the prevailing market rate at the time. What happens if the market rate drops to 4%? That is why the ‘call’ feature is built into bonds. The corporation may have the option to ‘call’ the bonds (i.e. retire the debt) to take advantage of the better rate. Since it is an ‘early retirement’ of the bonds, it creates a possible capital gain situation for the investor. Therefore, would Clinton’s plan actually be onerous to corporations wishing to borrow money? It’s a whole subject unto itself, but would this result in the elimination of ‘call’ features to protect investors from the higher capital gains taxes?