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Hillary Clinton’s proposal to increase capital gains taxes on short-term investments in order to incentivize key corporate officers to invest in the long haul has been the subject of widespread debate in recent weeks. As I note in my new column for Defining Ideas from the Hoover Institution, however, the shortcomings of the former Secretary of State’s proposal run deeper than debate over the cap gains rate suggests:
Start with this question: Is the proper object of taxation income or consumption? Right now, we tax income, but as a matter of principle that decision is highly suspect, because of the extra taxation it places on personal savings, savings that become the capital investments Clinton wants. Any capital gains tax, either long-term or short-term, exerts a lock-in effect on investors that makes them reluctant to sell their current investments to buy new ones.
An investor who pays a 20 percent capital gains tax to the government has less money to invest in a new project relative to an old one. Thus, he may well be reluctant to make that shift even if the new investment promises a higher rate of return than the old investment. The numbers may not add up given that he is working off a smaller investment base. A decision that reduced the capital gains to a zero rate would, after transactions costs, leave the same amount of money to invest in the new project, which makes it easier for capital to move to its higher value use. In the alternative, the zero tax rate could be extended only to those capital gains that are reinvested in other similar ventures within, say, a 30-day period.
Note that the dangers of lock-in explain why the Clinton proposal is upside down. First, the Clinton proposal is likely to reducetax revenue as it lowers the rate of investment and postpones the turnover among investments. This second consequence is very serious because a sensible investment strategy depends on skilled investors cashing out of mature investments that are now lower risk in order to reinvest in new high risk ventures that can benefit from their expertise.
You can read the argument in full here.