Democratic presidential front-runner Hillary Clinton recently put forward a proposal to raise capital gains tax rates for top-bracket investors who sell assets that they’ve held for less than six years. One obvious concern with the proposal is its potential to discourage saving and business investment. But, the proposal has another critical flaw. It reinforces tax provisions that lock investors into their portfolios, penalizing them for switching to different assets when their investment needs change.
Capital gains taxes create a lock-in effect because investors don’t pay tax on increases in the value of their assets until they sell them. That gives investors an incentive to delay selling in order to postpone their tax payment – pushing taxes into the future is attractive because a dollar paid tomorrow is worth less than a dollar paid today. Also, if an investor hangs onto an asset until she dies, the capital gains tax is completely avoided – the investor and her heirs are never taxed on the appreciation that occurred during the investor’s lifetime.
This lock-in effect is harmful because it discourages investors from adjusting their portfolios. An investor holding stock in the Jones Company may want to sell that stock and move into Smith Company stock, which she thinks has better prospects. Or, she may want to sell stocks and move into bonds to lower her risk exposure. Because selling would speed up her capital gains tax payment, though, she may end up holding on to the Jones Company stock.
That’s not just theory. Numerous statistical studies, including a recent study by three economists at the Joint Tax Committee and the Congressional Budget Office, confirm that capital gains taxes significantly reduce asset sales.
Simply raising capital gains taxes across the board would increase the lock-in effect. As the tax payments become larger, investors become more reluctant to speed up the payments by selling earlier.
But, Clinton’s proposal is worse than an across-the-board increase. It further compounds the lock-in effect by adopting a sliding scale that sets higher tax rates for assets held for shorter periods. Today, high-income investors are taxed at 23.8 percent on gains on assets that have been held for more than one year. To mention a few examples, Clinton’s proposed sliding scale includes rates of 43.4 percent for assets held between one and two years, 35.8 percent for those held between three and four years, and an unchanged 23.8 percent for those held six years or more.
Clinton’s sliding scale puts a second tax penalty on asset sales. Selling earlier not only speeds up the capital gains tax payment – it also raises the tax rate. That extra penalty turbocharges the lock-in effect, further discouraging investors from adjusting their portfolios.
The amplified lock-in effect is no accident. In fact, it’s the whole point of the proposal. Clinton wants to lock shareholders into their portfolios in the hope that it will prompt corporate managers to emphasize the long run, rather than quarterly earnings, in their business decisions. But, her strategy is unlikely to work.
Investors who plan to hold a company’s stock for longer periods may have a stronger desire for the company’s mangers to focus on the long run. But the individual investors affected by the proposed tax change are unlikely to have much power over manager’s decisions. Large institutional investors may have more influence. Many of them, such as pension funds, aren’t affected by capital gains tax rates because they’re tax-exempt.
In some cases, corporate managers’ short-sighted decisions may be a problem, but locking investors into portfolios that don’t meet their needs is not the solution.
