Yesterday morning, after I learned in the NYTimes that the capital gains tax would be 20% on assets held for a year, I wrote a note to House Ways&Means Chairman Bill Archer congratulating him on having resisted Treasury demands for an 18-month holding period and holding it at its current 12 months. In the note, I urged Archer to begin planning now for next year’s tax bill, to get the holding period reduced to at least six months, if not zero, where it ideally belongs. This morning, we now learn that Archer and Senate Finance Chairman Bill Roth in fact caved in to Treasury Secretary Bob Rubin. The holding period to get the 20% rate is 18 months, the longest holding period for a capital gain differential in the tax code’s history. The move sharply diminishes the value of the 20% rate to all riskier assets and thus in relative terms increases the value to mature corporations. It especially dampens the value of the lower rate to the smaller high-tech firms. It helps Microsoft and Intel, which are established enterprises with mature assets, because it discourages investment in their potential competitors. Why? Investors who might otherwise be attracted to them know they might be forced to sell before the 18 months, with the risks not compensated by a higher after-tax reward.
What did Archer and Roth get in exchange? They got a separate 18% capital gains differential on assets purchased after January 1, 2000, and held for five years. They gave up a bird in the hand today for a bird in the bush eight years from now. And a five-year holding period is almost completely useless in encouraging capital formation, except to add a bit of value to the least-risky corporations, such as banks, including Goldman, Sachs. Indeed, the very idea of a capital gain holding period stems from the notion that the Crash of 1929 might not have happened if investors at the top had been forced to hold on to their gains longer, to get the differential. After the Crash of 1987, that same mentality showed up in the presence of Nick Brady, whose Brady Commission argued the merits of “patient capital.” It produced the silly idea of closing down the market in order to prevent people from selling to people who want to buy -- the circuit breakers now in effect. On the margin, these measures simply push capital transactions into markets that will not close. The very idea of “patient capital” is nonsense, concocted by the keepers of the status quo. Capital is most abundant and available at the bottom of the economic pyramid when it is most fluid, which means it can get out as fast as it goes in.
In the same way, a holding period on capital gains is a tax without revenue. The worst kind of government regulation, it does damage and does no good. After Richard Nixon was inaugurated in 1969, he asked the corporate chieftains at the top of the Establishment what they would like from his new administration. He was told they preferred a doubling of the capital gains tax and a 12-month holding period instead of six. They were then asked to choose one, and they chose the higher rate. In the paradigm of old money, which has most of its capital gain behind it, an increased reward to risk-taking only encourages competition from the lower ranks. The 18% rate and these higher holding periods were supposed to offset Archer’s willingness to drop indexation of capital gains against future inflation -- an idea that has much less merit at the end of an inflationary era than at its beginning. It would have been much better if he had dropped indexation with nothing in exchange.
The good news is that this is not the end of the fiscal process in the 105th Congress -- although the President and GOP congressional leaders are acting as if it were. It was clear on Monday, when we reported that we would not be unhappy to see the legislation sidetracked until September, that there is a lot of bad stuff in the bill that has to be fixed. Once Congress gets out of town, there is also going to be a lot of unexpected revenue showing up that has to be dealt with. If there is no second tax bill, the revenues will of course be spent. Here’s how Jack Kemp summed up his assessment in a statement released from Empower America yesterday, before he had learned about the 18-month holding period:
There is good news and bad news in the tax bill that Congress and the President are about to enact, with the scanty tax relief barely outweighing the new welfare-state policies forced on the Republican Congress by President Clinton. It is a further disappointment that Congress had to abandon good policy ideas before the President would consent to sign the bill.
What is especially disheartening to me is that both the President and the Congress have concealed from the American people the fact that a large amount of unanticipated revenue is pouring into the Treasury as a result of the strengthening economy and robust financial markets -- so much so that the budget is likely to be balanced next year. Far from a dream come true, this tax bill is making the tax code a nightmare of tax credits and Washington-directed social engineering.
All of those unanticipated revenues should have been dedicated to a larger tax rate cut. Instead, the very existence of this additional revenue was hidden from the public. Conservative estimates indicate that revenues are likely to continue coming in at least $20 billion more each year than Congress anticipated when it passed the budget resolution in May. That is at least $100 billion more over the next five years. That underestimate of revenues is more than the entire tax cut that the President and congressional leaders are now congratulating themselves about!
The good news in the legislation is, of course, the lower capital gains rate, the higher exemptions on estate tax, and an indexing of the threshold on the alternative minimum tax. As small as these elements are in dollar terms, they each have powerful supply-side growth effects, and it is these that have been capitalized into the rally on Wall Street. This continued flow of fresh revenue at least might be enough to finance, on the come, an overhaul of the entire tax system. On the other hand, as Kemp points out, the bill “transforms the IRS Code into an embryonic cradle-to-grave welfare system by using the Code to generate welfare checks even for some people who pay no income tax and little or no Social Security payroll taxes. An entire class of welfare recipients, who pay no income taxes now, will have a vested interest in maintaining and even expanding the maze of refundable credits. The Speaker of the House, in fact, already started the bidding war for the further entrenchment of the current tax code by offering to raise the fully refundable child credit another $100 next year.”
As you can see, what we have witnessed this week is a prelude to the debates ahead. For all the frustration in watching this legislation hashed out the way it has been, it at least does more good than harm.