Tuesday, January 27, 2009

Capital Losses

Quick: name me one form of gambling income that isn't taxed at your normal income tax rate. Slots? Lottery? Multi-state Powerball? Nope. It's "capital gains" on stock sales.

If you talk to defenders of the capital gains tax, and especially those who have argued for it to be lower than regular income tax, they'll tell you about how important it is to encourage people to Invest In Companies That Provide Jobs And Other Good Things, and I completely agree. Except 99% of the shares out there are not actually shares that were bought from the company. There was absolutely zero capital invested In Companies That Provide Jobs And Other Good Things. By giving preference to the stock market, people are encouraged to buy shares from the people who do Invest In Companies, and ensures that they make a lot of money. But let's not kid ourselves that we're encouraging investment in companies.

If we want to encourage investment in companies, rather than encouraging the development of a financial industry that siphons off billions of dollars a year without actually producing anything (oh, except for the financial crisis we're experiencing now), we'd give preferential tax treatment only to the sale of shares that were purchased from the company, i.e. only those things that can truly be considered to be "capital".

What? This would discourage people from investing in the stock market? How do you figure? People were investing in the stock market before the drop in the capital gains tax rate. There's no lesser appeal to the money to be made by buying into the chance that someone down the road will be willing to pay more for your share, except people making that choice won't be able to make as much money as before. But why is this bad? What good does gambling on the market provide to the society, to warrant preferential tax treatment? Gambling on a company, sure, but when you buy a share of stock, you're buying a share of stock, not investing in a company. The stalwarts will continue to maintain that you should value shares based on the performance of the company that issued them, but really, come on. Did the dot-com bubble teach them nothing? The rationales people come up with to justify the different P/E ratios of different shares are just rationalizations. What it comes down to is this: for long periods of time, people implicitly agreed that stocks should be valued based on the underlying performance of the company, but that's just a principle, it's not a requirement, as we've seen all too well.

Let's take the company I work for: Google. In late 2007, its shares were trading north of $700 a share; this month, they're at $300 a share. What has happened to the fundamentals of the company in those 14 months? Still bringing in a heap of money quarter after quarter, with nice gains year over year, even as it expanded its workforce and costs significantly. Yet its "value" is down over 50%. Neither price is based on fundamentals: they're both based on opinion.

Buying stock is gambling, pure and simple. You're wagering that beyond some horizon with which you're comfortable, someone else's opinion of the company is going to make them willing to pay you more for your share than you paid for it. But don't kid yourself that you're "investing in the company": most of the time you're just paying off another person that took the same gamble you are.

So how about we get building businesses again: change the capital gains rate to apply only to the sale of shares that were purchased directly from the company, and make that same rate apply to interest earned from purchasing bonds, in both cases regardless of how long a person holds the instrument. Encourage investors to actually invest, not endanger the economy by frittering away money on more and more elaborate financial ploys.


Brent Noorda said...

I agree that trading in these young public tech companies stocks is the same as gambling, and is a baseless transaction (except as a gambling deal. And I'm glad you say so. But it seems different when a public company actually pays dividends, doesn't it?

ardeb said...

It is different: it's even worse, because the Bush administration managed to pretty much remove taxes on dividends, because "the company already paid taxes on that money." (Of course, by that reasoning, companies shouldn't have to pay taxes on any money they receive for the goods I buy, because I already paid taxes on that money.) So now you've got money that's not actually going to a company to fund jobs and innovation, and money coming out of the company (also not funding jobs and innovation) tax free. Where's the social good there that deserves preferential tax treatment?

curiouscat said...

It would actually make sense to index things to inflation. With computers today this would be easy. One of the big reasons to reduce the capital gains rates (originally) was you ended up paying tax on "gains" for your IBM stock you bought and then sold 20 years later and a big part of the "gain" was just inflation.

Indexing things to inflation wasn't practical in 1990. It is today.