Hillary's Shortsighted Capital Gains Proposal

Unlike Hillary Clinton, I have no idea whether short-term trading is good or bad for markets.  I do know that government has no business regulating it.

Under a plan put forward last week, Clinton would double capital gains taxes on assets held less than five years.  The proposed scheme would tax gains on assets held less than two years at 39.6% (plus an additional 3.8% tax for high earners included under Obamacare).  Assets held more than two years would be taxes at between 20% and 39.6%.  Even a three-year holding period would be subject to a 36% tax.  

Although this proposal would apply only to high earners at this time, bracket creep would eventually subject many middle-class taxpayers to the higher tax.  And all Americans would lose as a result of the distortion of markets resulting from Hillary’s proposal. 

The rationale for this revamp of capital gains rates is to force companies to seek long-term growth by forcing investors to take long-term stakes in companies.  Yet there is no consensus that increasing capital gains taxes would have any effect on corporate behavior.  With average tenure of less than five years, corporate CEOs are always going to strive to meet what Hillary calls “short-term” performance goals.

That is not necessarily a bad thing. Allowing an underperforming management team five years or more to carry on, as Hillary appears to suggest, won’t do investors or workers any good.  Free markets exist so that investors can vote not just with their proxies, but with their feet.  The freedom to shift capital from underperforming companies to better ones is essential to the operation of capitalism.

Clinton’s capital gains proposal, if enacted, would reduce short-term trading and even trading that is not now considered short-term (selling a stock or fund after three years or even one year is hardly “short-term”).  A five-year threshold would force most investors to hold assets for long periods of time regardless of performance or to move toward indexing so as to postpone most capital gains altogether.  It appears that Hillary’s advisors have not thought through the unintended consequences of this change. 

Hillary’s proposal is proof of the lengths to which progressives would go to impose control on free markets.  In her July 24 speech, Hillary attacked “short-termism” on the part of CEOs who strive to meet quarterly goals – presumably merely for the nefarious purpose of increasing their own compensation.  What Ms. Clinton fails to mention is the fact that public corporations have always set long-term goals and published them in annual and quarterly reports subject to SEC oversight.  Any CEO who failed to set long-term goals and seriously attempt to meet them would be out of a job.

Since Hillary and her husband have received tens of millions of dollars in speaking fees and foundation contributions from these selfsame corporations, she must be aware of the fact that corporations do already set long-term goals.  Why then would she employ such demagoguery in attacking corporations for “short-termism”?  Presumably, merely to advance her own campaign.

There are several major objections to Hillary’s capital gains proposal.  First, government has no business attempting to micromanage equity markets or to steer the behavior of CEOs toward particular ends.  Whenever government attempts such control, as it has many times in the past, the result is counterproductive.  In the financial crisis of 2008-2009, which resulted from government intrusion in mortgage markets, the result was a global economic collapse.

Certainly, the imposition of higher capital gains taxes would deter trading on the part of investors.  But would a reduction in trading translate into a greater emphasis on long-term thinking on the part of CEOs?

CEOs would still be under pressure to increase profits and revenues on a quarterly and annual basis, just as they have been from time immemorial.  Whether the standard of measurement is one quarter, one year, or five years, it is obvious that some standard must exist.  For progressives like Hillary Clinton, the problem is not really short-termism, but capitalism itself.  That’s why, in the same address in which she proposed doubling capital gains taxes, she promised to increase the role of labor organizing and increase minimum wages.  Decisions that should be left to the markets are to be taken over by Soviet-style central planners.

Hillary’s capital gains proposal would also result in the creation of markets in which assets would become significantly mispriced.  A reluctance to trade when assets become overvalued or undervalued creates pent up mispricing that can result in greater than normal volatility.  Curbs on trading pose a serious danger to financial markets.  The use of tax policy to dissuade investors from trading would not make markets safer, as Hillary would have us believe.  It would increase the likelihood of financial instability.

Yet another unintended consequence of Hillary’s half-baked proposal would be a reduction in government revenues from capital gains.  While it appears that her plan would increase revenues (for the purpose of funding ever greater expansion of government, particularly in the areas of health care and education), the actual effect of capital gains increases has always been to reduce revenues.  A large body of research exists, some of it conducted by Dr. Arthur Laffer, demonstrating that the effect of increased capital gains taxation is to dampen trading so as to reduce government revenues.  Investors will simply hold onto their positions rather than submit to tax rates of 43.4%, plus state and local taxes. 

It is investors themselves, including activist investors, who bring about desirable changes in CEO behavior.  By moving funds out of underperforming companies, investors signal the need for change in management.  By inhibiting trading, Hillary’s proposal would forestall this outcome and so make it more difficult to change behavior of CEOs whose conduct is not aligned with the interests of investors and workers.

The best medicine for the markets is not more regulation and taxes.  It is to allow markets to function as they were intended.  Hillary seems to be so eager to establish her progressive credentials that she has lost sight of how markets operate.  In other words, she’s more interested in winning the Democratic nomination for president than she is in creating economic prosperity for American investors and workers.  Now that’s what I call “short-termism.”

Jeffrey Folks is the author of many books on American politics and culture, including Heartland of the Imagination (2011).