Capital Gains Taxes, Risk, and Growth

The Biden administration is said to be set to propose increasing the capital gains tax and the top marginal tax rate on the wealthiest Americans.

Discussion of capital gains taxes often focuses mainly on their role in wealth distribution. There's no doubt that inequality, which the Covid-19 pandemic has worsened, is a major issue that needs addressing.

But there are other important issues at stake that need far more attention than they have gotten. In particular, we need to talk about the way that current U.S. tax policies treat risks by subsidizing dangerous risk-taking while failing to invest in heading off others. Both risk errors --one active, one passive-- have important implications for economic growth in the near, medium, and long term. Even investors who have benefited from the huge recent run-up in prices need to pay attention if they want to keep as much of their windfall gains as possible.

US policy —both our tax rates and Fed money printing— has been creating huge risks by what amounts to subsidizing casino gambling. These policies have made a speculative bubble bigger, worsened inequality, sucked money out of the real economy, and created a disaster waiting to happen. Raising the capital gains tax for the very rich would be one step toward fixing those errors.

As anyone who has heard me talk about the obvious and impactful gray rhino risk of financial fragilities knows, I have been deeply concerned for quite some time about the gap between the price of financial assets and their underlying value. Anyone who follows financial liquidity cycles is concerned for the same reason. The Federal Reserve and its counterpart central banks around the world cannot keep printing money forever.

First, extremely loose monetary policy has already created asset price inflation and is starting to show up in the real economy as well. Look at lumber prices, for a starter. Or go to the grocery store. These inflationary pressures already are making investors nervous, as we saw with recent bond market jitters.

Second, the longer an extremely loose monetary policy continues, the less effective it will be in stimulating the economy. That means there will be no more arrows in the quiver when the next crisis happens. Record high corporate and government debt at some point will make it harder and more expensive to borrow, and central banks already have little room to lower interest rates further. (Part of the reason that low interest rates have not been more effective is that big investors and companies have reaped the lion's share of the benefits; witness the failure of the Fed's Main Street lending program. But that's a whole other conversation.)

Third, these very same low interest rates have created asset price inflation which in turn is hurting the real economy --the companies, workers, and consumers who together fill pockets on payday and make cash registers hum. With central-bank fueled financial markets continuing to rise, people and companies see a safer bet in putting their money into paper assets than into businesses and people. That's why we've seen a new surge in corporate share buybacks, which recently hit a new four-week record: companies simply don't see the future demand to justify investing in themselves.

This dynamic has a clear cause rooted in a tax policy that subsidizes financial market investing over the real economy. Even after the 2017 corporate tax cuts, businesses pay higher tax rates (at least before taking into account loopholes) than do investors in the secondary markets, especially those who hold securities for a year or longer, who are lucky enough to have capital gains.

The Biden administration has also floated the prospect of raising the corporate tax rate. This is a whole other debate, but one thing is very clear: Doing so without adjusting the capital gains tax appropriately would only increase the subsidies we give to the already financialized economy while sucking even more money out of the real economy. 

If you don’t like taxes or subsidies, fair enough. I hear you. Anyone in this school might consider that a hike in the capital gains tax would merely be offsetting subsidies conferred by the Federal Reserve and Treasury.

The argument that helped get capital gains taxes lowered in the first place was that this was a way to encourage investment and raising money through the capital markets. But this is a very inefficient way to get money into the economy, especially for smaller businesses that are unlikely to ever list on the Big Board or elsewhere.

Concerns about a tax hike hurting smaller investors are valid. But this group is protected to some extent from a capital gains tax hike by 401k and other tax protected plans, and by the fact that the higher capital gains tax rate mainly applies to the very richest.

The administration could structure the new tax plan in many ways. The biggest capital gains subsidy to financial market investors comes from shares held for a year or longer. It's important not to discourage people from holding shares for longer periods, because this helps to stabilize markets and encourage companies to make decisions with longer-term benefits instead of just chasing quarterly earnings targets. Along these lines, nuances to consider might include taxing high frequency trading, which creates added risks by heightening volatility that I have a hard time seeing as justified given the minimal economic value they create. The administration also might consider redefining "long term" from the current 1 year minimum, which is not most people's idea of "long term" and creating tax incentives for longer periods.

As with any plan, the devil will be in the details. But it's important to recognize that changing the relationship between capital gains and corporate taxes could create economic benefits that could help the real economy to catch up to market valuations and slow or cushion the inevitable market downturn. That is an argument that investors should not ignore.

This article is part of my LinkedIn newsletter series, “Around My Mind” – a regular walk through the ideas, events, people, and places that kick my synapses into action, sparking sometimes surprising or counter-intuitive connections. 

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