Several weeks ago, Federal Reserve Chairman Alan Greenspan, choosing his words very carefully, warned that the stock market was becoming a bubble. The market lurched, recovered, and kept climbing. Wall Street decided--correctly, it seems--that Greenspan was not so worried that he might raise interest rates merely to spite the stock runup. But Greenspan had a point. Stock prices are now higher, relative to actual and anticipated earnings, than at any time since the 1920s.
Chairman Greenspan speaks out on policy issues more than most of his predecessors did. He has, for example, urged Congress to deflate the consumer price index, and he strongly supports fiscal discipline. If Greenspan truly wishes to temper the "irrational exuberance" of financial markets, however, he would do well to express himself on two other policy ideas--one of which is now on the fast track to bipartisan approval, the other of which is anathema to Wall Street and most legislators but dear to many economists. I refer to a capital-gains tax cut and also to the idea of a small tax on financial transactions.
Cutting the capital-gains tax is suddenly back in fashion. During the 1996 campaign, President Clinton tried to head off a general capital-gains tax cut by supporting capital-gains relief for homeowners and tax credits for families with children instead. But because of Republican prodding, Congress may well enact a general capital-gains cut, with Democrats clambering on board to share the credit.
NARROW SLICE. This is a bad idea on three grounds. First, any stock market that has doubled in four years and quadrupled in a decade does not need additional stimulus. The danger facing Wall Street today is further euphoria, not insufficient reward for investors. Second, since wealth is far more highly concentrated than income, a capital-gains cut would bestow tax relief on a narrow slice of Americans: the very rich. More than 40% of stocks are held by the richest 1% of people. Capital gains in the more broadly distributed forms of shareholding, such as pension plans and life insurance policies, are already tax-exempt.
What's more, general capital-gains relief would widen the budget deficit. This, in turn, would increase pressure to cut government outlays that benefit lower-income people. And wider deficits would raise the risk of higher interest rates. In an era of low inflation and booming stock prices, general capital-gains relief is simply gratuitous. If we cut capital-gains taxes at all, relief should be limited to investments held for very long periods.
If anything, we need to use tax policy to damp down the volatility and euphoria of financial markets. One sensible remedy, first proposed more than two decades ago by the Nobel laureate James Tobin, is to levy a small tax on foreign exchange transactions. The idea, recently resurrected in a collection of papers (The Tobin Tax: Coping with Financial Volatility, edited by Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg, Oxford University Press), is that a tiny tax, say 0.2%, would be a trivial burden on genuine investments but a useful deterrent to transactions that were mainly speculative.
TEMPER THE SWINGS. A Tobin tax might be levied on all financial transactions, but its logic applies with special force to the global foreign exchange market, which now totals $1.3 trillion a day--but which is a zero-sum game. (That is, one trader's gain is always matched by another's loss.) As Professor Tobin observes: "A 0.2% tax on a round trip to another currency costs 48% a year if transacted every business day."
Applied to international currency transactions, a Tobin tax would temper the swings in foreign exchange markets and lead to more stable exchange rates. Levied on international portfolio investment, it would cool the problem of hot money and reward investment for the long haul, which is surely what emerging economies need from global capital markets. To work, a Tobin tax would require increased convergence and coordination in the taxing and regulatory policies of the major nations, a worthwhile objective in itself.
Besides punishing pure speculation, the Tobin tax would also raise a lot of money--at a time when legislators want to reduce deficits but are tempted to open up new loopholes. Even a tax of 0.2% would generate several tens of billions of dollars a year--more than enough to finance a cut in capital-gains rates on very long-term investment. It's a perfect trade: Limit capital-gains relief to long-lived investments, and raise taxes on pure financial speculation. Over to you, Chairman Greenspan.