Clinton’s dumb tax plan
Last Friday, Hillary Clinton, leading Democrat aspirant for the U.S. presidency, proposed a remarkably poor idea — to tax “short-term determinism” with higher capital gains taxes on assets held up to six years before being disposed. The proposal affects only the highest-income individuals.
Seems that Hillary Clinton is engaging in a new form of class war rather than sensible tax policy. It is far from clear that a short-term focus on earnings has any relation to the length at which assets are held by only the very rich. The proposal will especially have no effect on the biggest investors — financial institutions and tax-exempt pension plans — who face no tax advantage or disadvantage when disposing of assets in the short term.
Not only will this proposal flop by not curbing investor focus on short-term earnings but it will also create new distortions and opportunities for complex tax planning.
Under the current U.S. system, net capital gains on assets held for less than one year are taxed as ordinary income. Longer-term capital gains are taxed at a 15 per cent rate. In 2013, a 20 per cent rate on net long-term capital gains was introduced for those taxpayers in the highest federal income tax bracket (39.6 per cent tax rate).
Given that investors postpone capital gain taxes by holding assets for longer periods, “short-run determinism” is curbed since long-held assets are already favourably taxed once taking into account the time value of money.
Further, net short-term capital losses, which can be deducted from up to $3000 of other ordinary income, must otherwise be claimed against net long-term gains. These complicated provisions already result in an enormous tax on risky short-term assets since the government fully shares the short-term gains but less so the losses.
Clinton’s proposal sets up six differ- ent capital gains tax rates for the highest income taxpayers, depending on the length of time that assets are held before being disposed. The highest tax rate of 39.6 per cent will apply to assets held for less than one year and then taper to lower rates based on the length of time the assets are held (a 20 per cent rate applies if assets are held for at least six years).
This complex proposal creates all sorts of distortions for taxpayers. Investors, rebalancing their portfolios, will have less incentive to invest in assets held for less than six years compared to the existing system. This can raise the cost of capital for businesses as well as undermine an investor’s financial performance.
The proposal also worsens the double taxation of investment returns in the United States under the corporate and personal income tax. With a federalstate corporate tax rate at over 39 per cent, reinvested profits that increase the share values leads to another tranche of personal taxes on capital gains up to 39.6 per cent. These higher taxes on equity income encourages companies to finance investment with debt as well as encourage businesses to organize themselves as pass-through entities rather than corporations. The Clinton proposal therefore aggravates further double taxation of corporate equity investments.
While a case can be made to reduce capital gains taxes on longer-term assets given the lack of indexation for inflation, differential tax rates on assets according to term length are difficult to administer. Accounts need to be kept for each type of asset according to dates. Some sort of ordering rule is needed to determine how capital losses arising from shorter-term sales would be applied to net capital gains on assets held for longer periods. The opportunities to time asset disposals to minimize gains and maximize losses with complex financial derivatives quickly evolve.
The United Kingdom similarly had a tapering approach whereby tax rates fell as assets were held for longer per- iods. The system became so riddled with complexity and unfairness that it became impossible to administer properly. It was abolished in favour of a simplified system (the UK now has a 28 per cent flat tax rate on all net capital gains with 18 per cent for lower income investors).
Like the UK, the Canadian tax on capital gains is relatively simple. One-half of net capital gains is included in income no matter the length of time assets are held. The lower tax on capital gains recognizes that such income has already been taxed at the corporate level.
Rather than adopt the bizarre U.S. system, federal and provincial governments should avoid double taxation of equity income under the corporate and personal tax systems. While past practice is to keep the top capital gains tax rate (roughly 25 per cent) aligned with the top dividend tax rate, existing dividend tax rates, which ensures parity between taxes on corporate profits and other ordinary income, are well above the capital gains tax rate. This increases the incentive to pass out income in the form of share buybacks rather than dividends to investors.
Given recent smart corporate tax rate reductions, capital gains taxes should have been increased as well. For example, the top federal-provincial capital gains tax rate in Ontario is almost 25 per cent while the tax rate on eligible dividends companies is about 34 per cent. To ensure full integration of corporate and personal taxes, the inclusion rate for capital gains should be raised from onehalf to two-thirds.
Capital gains taxes are extraordinarily complicated in most tax systems today. The Clinton proposal goes in a direction that only makes it worse with little economic gain. Canadian policy-makers should avoid such short-run political tinkering and thinking.