I am stunned at the stupidity of Hillary Clinton's policy
proposal to combat purported "short-term capitalism". I say this as someone who contributed to her
campaign in 2008 and wishes she, not Barack Obama, had been elected President that
year. And my objection does not go to
whether the goal is a good one, which I have views on, but will set to one side
for now. Rather, my objection is, if you
wanted to correct "short-term capitalism", increasing the capital gains tax based on duration of holdings is so obviously
ineffective, I call into question whether anyone with any grasp of stock market
dynamics was involved in formulating the proposal.
1. The Little Guy is Not The Problem. Investors
who pay long-term capital gains taxes are not responsible for most stock
trades. The vast bulk of trading is
done by either (a) tax-exempt institutional investors, like pension funds,
mutual funds, hedge funds, charitable and university endowments, etc. or (b) financial institutions which, while
taxable, change their portfolio daily and already have their profits and losses
taxed as ordinary income, so will not be affected by changes in capital gains rates. Just a small fraction of volume comes from people who pay long-term capital gains taxes. I don't even know if there are any stocks in the S&P
500 as to which non-management, non-institutional holders hold a majority of the outstanding
shares.
2. Compensation Formulas Drive Short-Term Focus. Even when
an asset manager is subject to long-term capital gains taxes on his or her
individual holdings or share of the fund s/he manages, any tax incentive to
hold a position is likely to be offset by the terms of pre-tax compensation, which are generally a function of (a) assets under management (AUM) and (b)
performance (alpha). As well, being able
to show the other investors in the fund a record of above-market performance
enables the manager to retain or attract more funds or reduce any concessions
given in pricing initially. Just to give
a simple example, imagine a $1B fund whose manager owns a rather large 10% of the capital in
the fund; assume it is unleveraged, to simplify things; and has the standard "2%
of AUM & 20% of profit" fee structure. If the manager produces a 20% gain, even if
his or her own share of that gain is taxed at 50%, costing $10 million, that
tax hike is dwarfed by the incremental income received for generating the gain
(2% of the additional $200MM under management is $4MM, while 20% of the $200
million profit is $40 MM, so the manager is up $44 million). Even after you deduct taxes on that income, say
at the same 50% rate, the manager is still way richer for having focused on
short-term performance.
3. Losses? Short-term trading is not limited to selling quickly just to book
a capital gain that gets taxed. Every month, there are stocks
that plunge right after an earnings report or change in guidance. And a good number of the persons selling are
taking a net loss on a position they built up in anticipation of a previously
favorable trend continuing into the future (a/k/a the long term). Think of the people who bought fracking companies just a year ago because U.S. energy independence was a
solid long-term trend. A
capital gains tax hike has absolutely no effect on those trades because they produce no gains, only losses. It may even encourage them, because the
losses they produce can be used to offset short-term gains in other positions. Or, the flip side of the same coin, since the
tax code limits the deductibility of net capital losses, the existence of a
capital loss in one's portfolio can actually cause one to sell another position
that carries a matching gain, so as to soak up the tax benefit of the loss.
4. M&A? To illustrate this, here is an anecdote: I bought shares in a
biotech company earlier this year. Its
drugs in trials had amazing long-term prospects if the trials proved successful, and
I had no monetization event in mind when I bought in. Two months later, a larger company apparently
agreed with my assessment and swooped in and struck an all-cash deal to acquire
the company at about a 50% premium to my purchase price. There was nothing short-term in any buyer's
mind, mine or the acquiror's. Yet the
Clinton proposal would characterize my gain as if it were part of a supposedly
evil short-term investing philosophy.
I would analogize Clinton's proposal to a school that has a
small population of bullies and announces that, to combat their bullying, they will raise
tuition. Or a proposal to curb gasoline
usage by raising the luxury tax on purchasing sports cars. The mismatch between (1) the actors and
actions that precipitate the supposed problem and (2) those who pay the
increased tax is so great, it verges on
the absurd.
If you wanted to curb short-term trading, among the many
better devices would be an excise tax on the aggregate number of trades of less
than the desired duration, or on the aggregate dollar amount of such
trades or on portfolio turnover above a certain level, possibly graduated the further the taxpayer went from the desired norm. That would pick up the institutional holders
who do most of the trading, regardless of their exemption from income taxes,
and it would also capture short-term trades to cut losses. It would also exempt sales in M&A
situations, because those aren't considered trades generally in brokerage
reports. In other words, it would avoid
all of the idiotic pitfalls of the Clinton proposal.
That said, there is a whole roster of macro-level objections
to the proposition that "short-term
capitalism" should be curbed at all, either because it's a net-positive,
or net-neutral, or just not net-very-bad and there are more significant
things to devote political capital to,
all of which I will leave for another day or voice to develop further.
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