Hillary Clinton's Fix for Short-Termism? They Tried It in 1934

One thing she didn't mention: the last time the U.S. taxed capital gains roughly the way she wants to was during the depths of the Great Depression.

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Hillary Clinton didn't mention 1934 in her speech today about fighting short-termism, but she could have. The last time the U.S. taxed capital gains roughly the way she wants to was from 1934 to 1941, from the depths of the Great Depression to the eve of World War II.

In other words, when it comes to tax policy, everything old is new again. In a speech at New York University's Stern School of Business, the Democratic presidential candidate said that giving preferential tax treatment to investments that are held longer would give investors an incentive to be more patient so companies could embark on projects with big upfront costs and long-term payoffs. "We need a new generation of committed, long-term investors to provide a counterweight to the hit-and-run activists," Clinton said.

Will it work? It's hard to say. Economists have found little to no linkage between capital gains tax rates and growth rates of the U.S. economy over the years, says Len Burman, an expert on the topic who is director of the centrist Urban-Brookings Tax Policy Center in Washington. "I'm sympathetic with the goal of encouraging long-term investment," Burman said, but added, "I don't think it's really going to do what she thinks it's going to do. ... I don't think this is a particularly well-designed instrument." 

Capital gains taxes have fluctuated drastically along with changes in who runs Washington and also changing advice from the economics professoriate. From the start of the income tax in 1913 until 1921, capital gains were taxed the same as ordinary income, such as wages. Taxes on investments held for a longer period have been taxed lower most of the time since, with one year being the most common cutoff for short- vs. long-term. But from 1934 to 1941, taxation was graduated a bit like the way Clinton is proposing. Instead of having a lower rate on longer-held investments, the Internal Revenue Service excluded part of capital gains from taxation.

"For example, in 1934 and 1935, 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively," according to an article by a Treasury Dept. staffer that was published in an encyclopedia. That changed in 1942, as the U.S. ramped up involvement in World War II and the tax system changed abruptly. There don't seem to have been any authoritative studies showing positive or negative effects of the Depression-era system—a difficult task considering everything else that was going on at the time.

Changing the tax code to combat short-term thinking is hardly a lefty fringe idea. Among the people who has been warning against short-termism in recent speeches is Laurence Fink, CEO of BlackRock, the world's biggest money manager, with more than $4 trillion in assets. "Even our tax code seems designed to encourage short-term strategies," Fink wrote in April in an essay on the website of McKinsey & Co., the blue-chip management consulting firm. "Paying significantly lower taxes for capital gains, a major component of tax policy, is predicated on one-year holding periods," Fink wrote. "Who really believes a one-year commitment is long term?"

McKinsey has also been warning that short-term thinking is harmful to long-term growth. "I don't think this alone will solve it but we've got to jolt the system out of its short-term mindset," Dominic Barton, the global managing director, said in an interview.

Capital gains are profits earned by selling investments for more than you bought them for. Clinton is proposing that the top 43.4 percent tax rate on short-term capital gains be extended to apply to assets held for less than two years, vs. the current one-year threshold. For two years and beyond, the tax rate would decline until reaching today's long-term rate of 23.8 percent for assets held six years or more. Those rates would apply to people in the highest tax bracket, those earning over $400,000 a year.

The trade group for private-equity investors is interested in what Clinton has to say. Private-equity investors usually invest for five to seven years, which would qualify them for low capital gains taxes under the proposal. "It seems like she wants to encourage investing for the long term, which is directly in line with the private equity model," says James Maloney, spokesman for the Private Equity Growth Capital Council.

But Clinton's plan also got some pushback. Alan Viard, an economist at the American Enterprise Institute, said it would "increase the tax system's bias against investment" by raising capital gains-taxes on investments held between one year and six years. He said it also worsens the lock-in effect—that is, it gives people a tax incentive to hold onto investments they would rather get rid of. That could involve keeping money in an old, tired company rather than investing in a promising start-up. Viard said that executive compensation might be a better avenue for addressing short-termism. (Clinton also said she wanted to do something about executive pay, including changing tax deductions on performance based pay, such as stock options.)

Burman, the tax scholar at the Tax Policy Center, said Clinton's implicit argument is that some activist investors force companies to abandon promising projects and return cash to shareholders, which the shareholders end up deploying in less worthwhile ways, Burman said. That may be true sometimes, he said, but if the activists did that routinely they would end up losing money. "Probably a lot of companies have cash on hand they don't have good prospects for. Activists are getting them to disgorge it. Unless they're systematically making misjudgments that's what you want  them to do."

Clinton's proposal was surprisingly specific—surprising because the detail gives her opponents something to shoot at. "I like when people are putting stuff out in the open," said Robert Wolf, founder and CEO of 32Advisors, a New York-based advisory firm, and a supporter of Democratic candidates. "It allows us to have a real debate. I'd rather have this debate on tax reform and how to get middle income wages moving again than the debate the Republicans are having , which is just kind of hard to follow."

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