Interesting news out of the HRC campaign yesterday. They’re considering tweaking the capital gains tax rate schedule to incent more patient holdings and push back on what they call “quarterly capitalism.” Though they haven’t formally announced anything, they’re talking about raising the top rate on assets held for the medium term from its current 24% to a number above the 28% proposed by President Obama in his latest budget, and then gradually lowering it for longer-held investments.
First, the motivation is correct. See the second figure in this post, showing that as activist investors have successfully pushed for more share buybacks and dividend payouts, the use of retained earnings for investment has tanked. That’s one reason why we’re stuck in a sluggish growth regime, even with very low interest rates.
From the WSJ:
U.S. companies in the S&P 500 index spent a median 36% of operating cash flow in 2013 on their buybacks and dividends, moves designed to deliver gains to current shareholders, compared with 18% in 2003. Over that same period, those companies cut spending on plants and equipment to 29% of operating cash flow, from 33% in 2003, according to S&P Capital IQ. When the companies have an activist shareholder, the changes are even sharper, the data show.
Second, the key move here in terms of tax policy, IMHO, is to nudge the capital gains rate closer to the rates of regular income. That both boosts the incentives to hold and reduces the (much stronger) incentive to define your income so as to take advantage of the low cap gains rate.
Remember JB’s first rule of tax policy: the moment there’s a preferential tax rate on X type of income, everyone with a tax lawyer suddenly discovers that X is in fact what they’ve been holding scads of all along. It’s a real coinky-dink!
Third, as tax maven Chuck Marr likes to say, the fact that cap gains is only taxed at realization is already a pretty big incentive to hold onto assets. So, while I think the HRC team is on the right track here, I’d consider more direct policies targeted at excessive buybacks and dividend payouts.
For example, as William Lazonick has explained, there’s an SEC rule that allows corporate executives to engage in stock buybacks as long as a) they announce the buyback program and b) the amount of shares bought back “does not exceed a ‘safe harbor’ [from prosecution for price manipulation] of 25% of the previous four weeks’ average daily trading volume.”
There are two major problems with this rule: first, the 25% limit is too high. Large, highly traded companies like Exxon Mobil and Apple can regularly purchase hundreds of millions worth of their own shares. Second, the fact that the SEC does not require companies to report daily stock repurchases makes the rule impossible to regulate without a special investigation, which the SEC rarely launches. As Lazonick puts it, the rule essentially legalizes “stock market manipulation through open-market repurchases.”
These problems could be fixed by lowering the “safe harbor” share—Lazonick goes further and would ban open-market repurchasing, allowing only “tender” offers (where the company offers to buy outstanding shares at a premium)—and increasing reporting requirements. Either way, public companies who believed their shares are undervalued could still raise their value by buying back shares—just not as much as today, as these rule changes would make such activities less common.
Finally, while I totally endorse these SEC changes (and have a piece out soon on how a financial transaction tax could also help here), I may differ a bit from fellow travelers in this investment incentive space.
Warren Buffet often hits this theme: “Never did anyone mention taxes as a reason to forgo an investment opportunity that I offered.” What drives investment choices is the expected return on that investment. That’s after-tax return, so of course taxes matter. But my sense is that there’s been a dearth of decent investment opportunities with promising returns, again, even at very low interest rates.
What would change that? Actually, the low inflation environment is unhelpful here as it drives low expectations by companies regarding future earnings; firms sitting on cash can beat inflation with financial “innovations” rather than investments in new machines, plants, and workers.
But at the end of the day, what would help most would be good, old-fashioned stronger demand. OTEers know that for me, this also implies a lower trade deficit. The recent strength of the dollar has not been helpful in this regard, as our manufacturers, a key source of capital investment, have been losing competitive ground (the stronger dollar also contributes to lower inflation).
So nothing wrong and a lot right with making policy changes to incent more patient capital and push back on “quarterly capitalism.” But I suspect that’s not where the big investment elasticities lie. To go there, we need more robust demand and growth.