Democratic presidential frontrunner Hillary Clinton last week released a proposal to overhaul the capital gains tax, which is paid on profits from the sale of investments. The detailed plan was designed to counter the pursuit of short-term gain at the expense of long-run investment – what Clinton called “quarterly capitalism” – by making it more expensive to sell stock in public companies that has been held for less than two years.
The problem, according to Len Burman, the director of the Urban-Brookings Tax Policy Center, is that it won’t work.
“The proposal suffers several defects,” Burman wrote in an analysis published Tuesday. “First, the campaign’s diagnosis of the problem -- that ‘activist investors’ strip cash away that firms would otherwise direct to investment (and more jobs) -- is not a compelling rationale for policy intervention. Second, even if it were, it’s not at all clear that Clinton’s tax-based prescription would cure the problem. Only half of assets sold are held for more than a year and less than half of corporate stock is held by taxable investors.”
Under current law, investments sold after one year are taxed as regular income, with the addition of a 3.8 percent investment income surtax, meaning that the top effective rate for a high-income investor would be 43.4 percent (the top statutory tax rate of 39.6 percent plus the surtax). After the one-year mark, the top effective rate on capital gains drops dramatically because it is no longer treated as regular income. Those profits are subject to a 20 percent capital gains tax, regardless of the investor’s income tax bracket, though the surtax remains.
Clinton’s plan would extend the window in which capital gains are treated as regular income to two years and would only lower the statutory rate incrementally. To pay the rate on the sale of an investment currently held for a year and a day, an investor would need to hold the investment for six years.
Burman, a former Congressional Budget Office analyst who served for two years as Deputy Assistant Secretary of the Treasury for Tax Analysis in the Treasury Department during Bill Clinton’s second term, doesn’t believe it will have the effects she wants.
For instance, he argues, when investors pull cash out of a company, they are often doing it for a good reason. “[P]ulling cash out of the company—and paying tax on dividends or capital gains—only makes sense if the company’s marginal investments are underperforming by a substantial margin. The cash drain might hurt workers inside the firm, but the redeployed cash will create jobs elsewhere. Overall, the economy gains because the extracted cash is invested in more productive activities.”
Further, because such a high percentage of investments are held for a year or less under current law, Clinton’s proposal might have the perverse effect of increasing early sales.
“There would be no incentive to wait until the one-year anniversary under the Clinton proposal,” he writes, “so the share of assets held for less than a year would increase. Moreover, the benefit from passing each of the holding period thresholds would be sharply reduced—4 percent of the gain or less compared with 19.6 percent under current law.
“More likely, investors will decide up front that some intermediate-term investments (one to 5 year holding period) no longer make sense.”
In the end, Burman disagrees with Clinton’s assumption that activist investors taking money out of companies are the major problem she thinks they are. More troubling, he says, are “passive investors who stand idly by while corporate CEOs pack their boards with cronies who rubber stamp outsized executive compensation and mediocre performance.”
However, he writes, “even if activist investors were a problem, this proposal is a poorly designed instrument to address it.”