As the details of the tax overhaul come dribbling out, I noticed one yesterday that seemed odd. There is a backdoor capital gains tax hike in the bill. Predictably, there was some outrage since there seems to be something to rage about every day these days. Cliff Asness wrote about how parts of the bill pick winners and losers instead of doing big-time tax reform. Personally, I think capital gains taxes are basically a disincentive to invest and a tax on risk capital. They are generally unproductive. Here is the crux of the capital gains tax hike.
If you buy stock and accumulate a position, the old tax law let you sell the most recent stock you bought and pay the least gain. In accounting terms, this is known as LIFO, last in first out. It might even be the case that you could sell the most recent stock you bought and have a loss to take in order to write off against other income. Your account still might hold a larger position in the stock, but you wouldn’t be taxed on it.
The Senate version of the bill changes the tax treatment to first in first out or FIFO.
Clearly, the reason they are doing this is that they want to make the bill as “revenue neutral” as possible which is a totally inept and dumb way to write a tax bill. There are a lot of economic factors at work when it comes to tax policies which are very hard to account for. What is the elasticity of the thing being taxed? What’s going to change with economic incentives? Will people work harder or less? Will they change their purchasing/selling/investment decisions? The truth is the predicted numbers never work out as predicted. Instead of projecting numbers they know won’t be right, they ought to be looking at overall tax policy, overall tax burdens, and stuff they want to incentivize.
The change only hits retail investors, which is the government picking winners and losers. The change will make markets less liquid, and liquidity is a key to market transparency. It turns out via data we know reductions and increases in capital gains have a lot of sensitivity to tax rates-meaning they are elastic. Reagan cut taxes from 28% to 20% and saw a big increase in investment and capital gains tax revenue. Bush 1 raised them and saw a decrease. Monkeying with capital gains is dumb.
In CFTC regulated commodities when December 31 rolled around all my positions were marked to market and I paid the corresponding 60/40 blended tax associated with them whether I had closed the position or not. The entire position in one particular commodity was averaged out for an entry price and marked to the December 31 settlement price. Depending on a person’s position, settlement discussions could get pretty heated on December 31 but I digress.
In this particular case if the tax bill writers wanted to get the best economic treatment for taxing gains on stock investing they would have used a weighted average formula. Multiply the number of shares you own by the price you bought them at and divide by the total number of shares. That gives you an average price. Compare that to the price you sold them at and boom you know your gain. It seems a lot less arbitrary than either LIFO or FIFO and actually tracks how humans behave in the market.
Stephen Green of Instapundit opines: Our current corporate tax code — a black hole of time-sucking, innovation-throttling cronyism — is perhaps the most enormous own-goal in modern economics.