My friend Michael Toth, director of research at the Civitas Institute, could perhaps be persuaded that he's incorrect about capital gains taxes. While he’s correct that the long-term tax on capital gains should be zero, he overstates the growth implications.
Much greater growth would come from zeroing out taxes on short-term capital gains. To see why, just consider what is accepted wisdom among economists, politicians, pundits, and supposedly even scientists: the power of compound returns is profound. Which is the point.
The potential for long-term wealth gained from investing is substantial, and this is true despite the certain horrors of long-term capital gains taxes. Toth is right that the tax is wrongheaded, and that zeroing it out would boost growth for, if nothing else, freeing up any realized gains for reinvestment. Just the same, the truth about the genius of compounding remains so powerful that tax or no tax, rare is the investor who will let taxes deter investment in pursuit of long-term compounding.
What’s true about long-term capital gains isn’t as true about short-term gains. In the short-term, the power of compounding is less visible. Since it is, the cost of investing for the short term is enormous, and logically an investment deterrent. This has the potential to sap economic growth for a variety of reasons. This opinion piece will touch on at least three.
A short-term tax on capital gains logically limits price discovery in the marketplace simply because the cost of being right about a corporation in the short-term is so substantial. The reduction in short-term capital flows born of excessive taxation has the potential to corrupt market prices to the economy’s detriment.
Only for the story to get worse. Investing for the long-term carries with it odd nobility inside the political class, and among investors who should know better. To believe this faulty, thoroughly simplistic, "quarterly capitalism" narrative, short-term equity market gains are those of seemingly nefarious “trading” in and out of stocks, while long-term gains are those of investors sticking with an investment theme over the long haul to the economy’s betterment. The viewpoint is total nonsense, and yet again inimical to growth. Think about it.
Since near-term exits from shares can be so costly in a taxation sense (gains are taxed as income), there’s a logical incentive among shareholders to hold purchases to avoid any kind of taxable event. Contemplate the economic negatives of just such an incentive.
Rather than capital rapidly flowing to its highest use as quickly as possible based on information reaching the marketplace in a manner as frictionless as possible, confiscatory taxation on short-term capital gains encourages investors to do not what is most economically efficient, but tax efficient. The consequence is precious capital locked up in ways that deter natural economic progress that's an effect of capital finding its best use right away.
After which, buying-and-holding “great companies” for the long-term might be the most overrated, economy, and return-sapping notion in investing. If readers doubt this, consider that when the 21st century began, GE (the bluest of blue chips) was the world’s most valuable company, Tyco the next GE, Enron the smartest corporation, Lucent the future of communications, and AOL/Yahoo the gold standard of the internet.
No doubt Toth is right. Long-term capital gains taxes should be zero as with short-term taxes simply because there should be no penalty for saving and investing. Still, and contra Toth, the real growth will come from taxing short-term capital gains the least.
