President Obama’s proposal to raise the capital gains tax is a good one, and overdue. No, you have not been redirected to Bloomberg – where the president never has a bad idea. This is about restoring the balance to corporate balance sheets. In fact, the tax disparity may already have damaged American capitalism beyond repair.
Stock buybacks boosted earnings per share by 4% or more on 99 companies in the S&P 500, simply by lowering the number of shares outstanding.
Absent tax policy, companies and shareholders should be indifferent to capital gains. If the company has one dollar per share to spend on dividends, and keeps it instead, then the value of the company will increase. Each shareholder can then take his dollar as a capital gain, at such time as it suits him to cash out.
The argument for a lower tax on capital gains is that, with a six or twelve month holding period, it encourages long term investment. Unfortunately, share prices are a lot easier to manipulate than dividends. Companies can borrow, for example, and use tax deductible debt to buy back shares.
Buybacks only make sense if the company has no prospects that will return more than its cost of capital – which, with Fed funds at zero, is not good news. When we look back on this one, it will be called the “buyback bubble.” Along with the capital gains preference, the buyback bubble is abetted by a high corporate tax rate, the tax deduction for interest, and stock based compensation for executives.
Apple is one of the many corporations that, rather than dip into its cash and take a tax hit, took out debt instead to fund a big stock buyback and dividend program.
President Obama should follow up with a proposal to end the tax preference for debt. Ironically, he has proposed a tax on bank assets – which the banks would not be holding if tax and monetary policy had not overstimulated corporate borrowing in the first place.
One good way to end the tax preference for debt would be to dramatically reduce the corporate tax rate. Everyone knows that corporate earnings are taxed twice – once, as income to the company, and again as income to the investor. Less well known is that this tax is regressive.
Let’s say Alice and Bob both own shares in the company and the company pays dividends. Alice, a wealthy investor, will pay tax on her dividends at a marginal rate of 39%. Bob, a working man, will pay 15%, but only after the company has paid its 39% – money that would have gone into his dividend. On the underlying corporate earnings, Alice and Bob are taxed at the same rate.
So, raising the cap gains tax is a good first step. Additional steps are:
- End the cap gains preference entirely, taxing all market returns as income.
- End deductibility of interest – all interest, starting with corporate debt.
- Reduce the corporate tax rate, so more income flows to personal returns.
- Raise interest rates.
- Crack down on HFT and other market manipulators.
These are not anti-capitalist reforms at all. On the contrary, they remove artificial preferences that have distorted our stock market. For example, we have the world’s highest corporate tax rate. Slashing it would repatriate $1.5 trillion, and make America more attractive for jobs and investment. We could make up the lost revenue through progressive taxes on the shareholders, not the companies.
In the old days, ordinary people could invest their savings and earn a good return. Stocks paid dividends, and bonds paid a decent yield. Marx said that “the people should own the means of production,” but capitalism actually made it possible. Americans would cherish their little slice of IBM or General Motors – and they could retire on it.
Broad based participation in the markets would be the best, or at least a partial, remedy for inequality. With an emphasis on unfakeable cash dividends, it would also restore the market’s proper job of allocating capital. The president’s policy objective should be to remove all the distortions – arising from tax policy, monetary policy, and failed regulation – which make the markets unsafe for ordinary people.
See also: Blame Canada