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Clinton’s capital gains sliding scale is a slippery slope

Published in The Hill

In her economic speech today, presidential candidate Hillary Clinton (D) proposed a sharp spike in the capital gains tax as an end to “quarterly capitalism.” Specifically, Clinton would replace the current maximum capital gains tax of 20 percent for investments held for at least one year. Instead, there would be a sliding scale of taxation similar to what was in existence under President Franklin D. Roosevelt: Less than two years, 39.6 percent (current income tax rate); two to three years, 36 percent; three to four years, 32 percent; four to five years, 28 percent; and five to six years, 24 percent. And only after six years would Clinton’s capital gains tax be as low as today’s maximum tax of 20 percent. (Clinton’s capital gains tax doesn’t include the additional 3.8 percent Medicare surcharge tax applied to capital gains.)

For decades, policymakers have been trying to find the tax-rate sweet spot on capital gains. I vividly recall the battle in 1978, when President Carter described the capital gains differential as “a huge tax windfall for millionaires and two bits for the average American.” He favored taxing capital gains at the same rate as ordinary income.

Carter’s plea fell flat in large part due to the reaction of Silicon Valley entrepreneurs who couldn’t raise capital in the U.S., due to the adverse tax climate. Many ultimately had to sell their companies overseas. Congress took note and decided to cut capital gains tax rates instead. I was asked by several members of Congress to come up with options. Here are the different ways capital gains can be taxed:

  1. Taxing as ordinary income is a double tax on savings and investment and hinders economic growth.
  2. Inflation indexing makes sure that taxpayers are not paying on inflation, but does not address entrepreneurial risk-taking.
  3. A flat rate is simple and takes care of risk-taking and economic growth, but is subject to criticism because it is not progressive.
  4. A rollover gets an A+ because it avoids any tax on savings and investment, similar to a consumption tax. But it is only limited to capital gains.
  5. The exclusion is great because it benefits all income brackets.
  6. At the end of the day, the goal should be no tax on savings and investment or a consumption tax. The rate should be zero or close to zero. Any carve-out for specific industry or type of asset or partially dealing with a problem should be avoided.

Then there is Clinton’s option of the “sliding scale,” in which the longer you hang on to an investment, the lower the tax rate becomes. That’s the way it was during the Roosevelt era. Initial press coverage is correct in observing that the Clinton sliding scale may be good politics. It appeals to the populist wing of the Democratic Party, which objects to the short-term “speculation” view of capital gains and likewise to certain elements of the business community. At a Wall Street Journalsummit in December 2014, multiple CEOs offered their perspectives on the toughest issues facing corporate America. Among their recommendations:

Structure the capital gains tax to create an incentive for investors to hold their shares for an extended period, reducing the tax rate as time goes on. It would discourage traders and attract investors, and help align executives’ interests with shareholders’. This would help U.S. companies grow, hire and compete in the global marketplace.

One of the biggest historical lessons of capital gains legislation is that it has to be bipartisan. For example, in 1978, the House GOP rallied behind a flat, low capital gains rate authored by Rep. William Steiger (R-Wis.). In the Senate, the legendary and wise Finance Committee Chairman Rep. Russell B. Long (D-La.) made the capital gains rate “democratic” through exclusion so that all income brackets benefited.

Of course, good politics does not always equate to good policy. The definition of “speculation” versus “investment” is in the mind of the beholder and the sliding scale became more of a slippery slope. Also, the idea of tying investments and tax rates to a politically imposed timetable, rather than market and economic conditions, ultimately made the sliding scale of the Roosevelt era unsustainable. Investors were too locked in and the country suffered.

In reality, a low capital gains tax rate has an important role to play in facilitating entrepreneurial risk-taking for new startups and broader economic growth by reducing the cost of capital. Consider the economic ramifications of being locked in, whether it is the horse buggy investor eyeing the invention of the automobile or the BlackBerry investor reading the tea leaves of Apple and Android.

Then consider the increased cost of capital that a longer holding period will cause. A longer holding period increases risk and thus requires a higher expected return.

Rates also impact revenue. There are numerous estimates that the revenue-maximizing rate could be as low as 15 percent.

Our standing in the global marketplace should also be considered. A report by Ernst & Young LLP compared today’s capital gains tax rates to major economies of the world, as well as major trading partners of the U.S. The U.S. capital gains tax rate compares unfavorably with those of many other major economies, including Canada, Australia, Japan and Russia. From the press reports of Clinton’s proposal, we would be even worse off.

In short, a politically expedient solution to capital gains might be the sliding scale, but economically it could become a slippery slope. Furthermore, successful capital gains tax reform has always been bipartisan and Republicans aren’t likely to buy in to the sliding scale. A better approach might be a consumption tax, which recently found bipartisan support in a report released by the Senate tax reform working group. In both Republican and Democratic tax reform plans that move our income tax into more of a tax on consumption and less on saving and investment needed for growth, there are provisions that offset the regressive impact on lower-income Americans. Under a consumption tax, all returns on capital would see a zero rate of taxation, including capital gains.

Presidents Franklin D. Roosevelt, John F. Kennedy, Ronald Reagan, Bill Clinton and George W. Bush all wrote their respective chapters in the history of capital gains tax reform. Our next president has an opportunity to offer a bold vision through tax policy that rewards savings and investment and promotes growth. May the best man or woman win.

Bloomfield is president and CEO of the American Council for Capital Formation. The Wall Street Journal dubbed him “Mr. Capital Gains.” He is on Twitter @MrCapitalGains.

WSJ: Who Would Have Guessed? Bipartisanship on Tax Reform.

Published in Wall Street Journal’s Think Tank

OG-AB456_THINKT_A_20140521152143The Senate Finance Committee announced Wednesday that five bipartisan working groups had completed reports analyzing the tax code and ways to make it simpler, fairer, and more efficient. It’s rare that Democrats and Republicans find common ground on any major issue in Washington, but on tax reform it is monumental. Business groups, interest groups, and other stakeholders in today’s system are scouring the reports to identify winners and losers among the recommendations.

Amid the many pages was a nugget that could have big ramifications for tax policy, the 2016 presidential election, and the economy.

Sens. Ben Cardin (D., Md.) and John Thune (R., S.D.), the co-chairmen of the working group in business income, note on Page 40 of their report to the Finance Committee: “Making a fundamental shift to consumption-oriented taxation is a major change that may not necessarily be undertaken in the near term. However, given the pro-growth effects of consumption taxes, the working group believes that the issues above and consumption-based tax systems in general deserve the attention of the committee as tax reform efforts continue.”

These few words confirm the consensus of many mainstream economists: A consumption tax produces more growth than an income tax.

The need for pro-growth solutions to economic malaise has reached global levels. Greece is desperate to find a way out of its austerity and bailout policies and to put itself on a path that creates jobs and growth.

Here at home, the need for economic growth to revive our still sluggish economy has transcended party lines. Hillary Clinton has stumped on it. Senators from across the political spectrum, including Ben Cardin, Rand PaulMike Lee, and Marco Rubio, have proposed versions of a consumption tax. Unlike the stigmatized European VAT, Sen. Cardin has proposed what he calls a “progressive consumption tax.” Sen. Paul suggests a “business activities tax.” The business-income working-group report says the joint reform plan of Sens. Rubio and  Lee “contains several provisions that would shift the tax code in the direction of a consumption tax.” On the business side of the Rubio-Lee plan, capital investment would be immediately expensed. On the individual side, investment income from capital gains, dividends, and interest would be tax-free.

This is not about importing a European-style VAT. Progressives, tea-partyers, and all points in between could craft a consumption tax tailored to the political, cultural and economic needs of our country.

To address conservatives’ concerns that traditional VATs pull in too much revenue for government coffers, Sen. Cardin proposes a rebate to taxpayers if revenues from a consumption tax exceed 10% of the economy. To counter charges of a “tax on the poor,” Sen. Paul would repeal the regressive payroll tax paid by the working poor and exempt from income tax the first $50,000 of wages.

These proposals capture the spirit of Ben Franklin’s admonition that a penny saved is a penny earned, while working around European pitfalls.

As Sens. Cardin and Thune noted, a consumption tax is unlikely to be adopted in the near term. But the 2016 presidential election may be the first and best chance to build a true mandate for tax reform, particularly for Republican candidates looking for a way to stand out in a crowded field.

Mark Bloomfield is president and CEO of the American Council for Capital Formation and co-authored “The Consumption Tax: A Better Alternative?” He is on Twitter: @MrCapitalGains.