On The Capital Gains Tax
4/25/2001 12:00:00 AM - Bruce Bartlett
Last Saturday, The New York Times reported that Senate Republican leaders hope to add a capital gains provision to the tax bill working its way through Congress. George W. Bush did not propose any change in capital gains taxation in his tax plan. The Times reports that one idea under serious consideration is to eliminate the capital gains holding period.
Under current law, gains on assets held less than one year are taxed as ordinary income at rates up to 39.6 percent. However, gains on assets held longer than one year are taxed at a maximum of 20 percent. And for assets acquired after Jan. 1 of this year and held for at least 5 years, the maximum rate is just 18 percent.
It is important to know that the tax treatment of capital losses also depends on the holding period. Short-term losses must first be netted against short-term gains, and long-term losses against long-term gains. Then, the net short-term gain or loss is combined with the net long-term gain or loss to come up with a final capital gains total. If, after all this, there is a net loss, then taxpayers may annually deduct up to $3,000 of such losses against other income.
Ever since capital gains first received special tax treatment in 1921, there has been a holding period of some kind to obtain a lower tax rate. It has changed many times over the years and varied between 6 months and 10 years. Nevertheless, despite the long existence of a holding period, there has never been a clear rationalization for it.
It is commonly thought that a holding period is desirable to discourage "speculation" and reduce stock market volatility. It is also said that encouraging investors to hold assets for longer periods has economic virtue. This view is shared by many corporate executives, who strongly prefer stockholders in their companies who hold their shares for long periods to those who trade frequently. But while corporate CEOs may indeed benefit personally from a long holding period, by reducing market discipline on their actions, it is not at all clear that the economy as a whole benefits.
Part of the problem is a logical fallacy -- assuming that because it may be economically beneficial to have more long-term capital investment, it means investors should be forced to hold on to their shares for long periods. This confuses tangible capital, such as plant and equipment, with financial capital in the form of stocks and bonds. It may well be economically beneficial to have more long-term tangible capital, but there is no reason why investors in stocks and bonds should be forced to hold on to their assets for long periods to accomplish this result.
Once a business has obtained the capital it needs for building new plants and acquiring new equipment, through the sale of stock or the issuance of bonds, why should the business care whether investors turn around and sell them? At this point, the physical investment decision is completely divorced from its financing method.
Unfortunately, the imposition of a holding period has economic costs for investors, who may reduce their investing as a consequence. It reduces liquidity and creates a "lock-in" effect that can cause market prices for corporate stock to vary from their fundamental value, thereby reducing economic efficiency. And these economic costs are not offset by reduced volatility in financial markets. There is no empirical evidence whatsoever showing that a capital gains holding period reduces volatility.
Another cost of the holding period is that aggregate investment is biased against relatively liquid assets such as corporate stock, and in favor of less liquid assets such as real estate. The average holding period in 1993 was less than 3 years for corporate stock, but more than 13 years for rental properties. This means that it is easier for the latter to get favorable capital gains treatment than the former.
Leonard Burman, formerly the Clinton administration's top tax economist, points out that the holding period may also reduce capital gains revenue. It encourages investors to realize short- term losses while holding on to long-term gains. That is because short-term losses are more valuable, since they can offset short-term gains that might be taxed as high as 39.6 percent. Thus, Burman notes, "some investors will realize short-term losses even if they are bullish on the asset's long-term prospects."
This suggests that abolition of the holding period might actually raise government revenue, even though it is usually treated as a tax cut by revenue estimators. They always assume that short-term gains that would otherwise by taxed as ordinary income will now be taxed at lower long-term capital gains rates, thus reducing revenue. But elimination of the holding period will also discourage the realization of some short-term losses, which may on balance raise revenue.
There have been no recent studies of the revenue effect of reducing or eliminating the holding period. However, a 1981 study by economist Steven Kaplan for the National Bureau of Economic Research and two studies by the New York Stock Exchange and the Securities Industry Association in 1983 all concluded that elimination of the holding period would modestly raise net revenue.
For these and other reasons, there has been bipartisan support over the years for lowering the capital gains holding period. Among the strongest supporters of doing so was former Sen. Daniel Patrick Moynihan, D-N.Y., former chairman of the Senate Finance Committee. In 1982, he introduced legislation to abolish the holding period, saying it would raise productivity and greatly simplify the Tax Code. Elimination of the distinction between long- and short-term capital gains clearly would have made life easier for taxpayers on April 16.
Those favoring elimination of the capital gains holding period are on solid ground. To the extent that there is justification for taxing capital gains at a lower rate than other income, there is no reason to differentiate between those held before or after some arbitrary time period. Requiring a holding period reduces the efficiency of capital markets and is unfair to investors who are either forced to sell or prevented from selling assets held less than one year.