A short-term bias is built into our capital gains tax regime. Eliminating this bias should be a key objective of much-needed tax reform.
The current conversation about the capital gains tax focuses largely on revenue generation and perceived equity of tax rates across income groups. While this is important, there is little public discussion, and even less public understanding, about how the short-term bias of the current capital gains tax adversely affects the investment behavior of fund managers and corporate executives and the rate of truly transformative innovation in our economy. There is even less discussion and understanding of how this short-term bias also invites institutionally supported corruption—such as the gaming of accounting and SEC rules.
Our capital gains tax has two important features that influence investment decisions and management behavior in general: the tax rate on so-called long-term capital gains, and the holding period required for asset sales to receive capital gains treatment.
The Tax Rate Issue
While the American Taxpayer Relief Act of 2012 mandated an increase in the capital gains tax rate from 15 percent to 20 percent for high earners, the all-important differential between the ordinary tax rate and the capital gains tax rate was not narrowed. Such a narrowing would have greatly weakened the current tax preference accorded to capital investment, thereby weakening incentives to invest. This tax preference reflects several long-standing policy goals: increasing the flow of funds to the investment process by essentially lowering investors’ cost of capital and increasing their potential returns; stimulating risky investments in innovations with high potential returns; promoting entrepreneurship; and accelerating GDP and job growth.
In the end, the differential between ordinary income and capital gains tax rates was not reduced because both rates increased in tandem by nearly 5 percent for individuals/couples earning more than $400,000/$450,000. In retaining this differential, Congress was able to fend off, for the time being, complaints that the lower tax rate on capital gains (and dividends) is inequitable because it primarily benefits wealthy taxpayers.
The Holding Period Issue
What was not discussed in the run-up to the compromise bill was a policy advocated by such diverse business groups as the Business Roundtable Institute for Corporate Ethics and the Aspen Institute—namely, an increase in the differential between long-term and short-term holding periods as a way of encouraging long-term share ownership and investment horizons. We should support this position—as long as the “long-term” is defined appropriately.
A long-term capital gain is essentially defined by the required holding period for capital gains treatment. Unfortunately, and quite ironically, this implied definition of the long-term has embedded a pernicious short-term bias in our tax regime.
According to our tax code, any gain accrued after more than 12 months is considered long-term and taxed at a substantially lower rate than ordinary income. This means that the tax code treats a 366-day investment exactly the same as, say, a 5-year investment, even though there is a world of difference in their potential impact on investment behavior and executive decision-making in general.
The undifferentiated holding period required for capital gains treatment has two perverse effects. First, by failing to distinguish between truly long-term gains and, say, a 366-day gain, and by failing to treat these two cases differentially, the holding period provision contributes to a short-term business culture where the investment time horizon and risk preferences of fund managers and corporate executives shift towards the here and now. There is little positive incentive for fund managers and corporate executives to behave in ways consistent with two of the primary objectives of our capital gains tax regime—stimulating innovation and economic growth. Second, as I argue below, our increasingly short-term business culture invites various forms of lawful but corrupt behavior that weakens the social contract between business and the citizenry at large.
The Curse of Short-Termism
Short-termism in business is the result of many factors. In addition to the short-term bias in current tax policy, these include an equity market geared to the quarterly earnings cycle for public companies; the ever-present danger that large pension funds, universities, sovereign wealth funds, and other investors can easily pull their monies from investment managers in response to underperformance vis-a-vis some current performance index; perverse financial incentives put in place for fund managers and corporate executives; and our tendency as human beings to discount the value of long-term outcomes while ignoring the long-term consequences of doing so (“hyperbolic discounting” in the jargon of behavioral economists)—all of which tends to push corporate executives towards projects with clear and immediate payoffs and away from more speculative undertakings with the potential of transforming science, technology, and a wide range of future goods and services.
The one driver of short-termism that is firmly within our control and ability to change is capital gains tax policy. It is a critically important driver because it directly influences the powerful, largely short-term incentives under which most fund managers and corporate executives operate.
One of most unambiguous indicators of the rise of short-termism in contemporary business is the increasing turnover rate of equities held by purportedly long-term investment funds and other investors. Over the past 40 years, the average holding period for U.S. equities across all investor groups has dropped from seven years to about seven months. A portion of this increased turnover has no doubt been created by hedge funds, which now account for nearly half of all stock trades. Their rate of equity turnover can reach as high as 1,200 percent.
Similarly, “hyperspeed” traders, who now account for as much as 70 percent of daily trades in U.S. equities, only hold stock for a few seconds. These “investors” have zero interest in an investment’s long-term value. Neither do they have any strong incentives to change their investment strategies. Aided by the near instantaneous pricing and re-pricing of financial and real assets, they remain riveted on making money from short-term price fluctuations rather than from researching the fundamental strengths and long-term prospects of individual companies.
Not surprisingly, many corporate executives operating in this casino-style capital market have been forced to adopt reduced time horizons in virtually everything they do. Most alarmingly, they have weak incentives and minimal rewards for investing in transformative research and product development, which require long lead times to market. Indeed, executives can be severely punished financially for such an investment strategy, especially when an absence of intermediate returns contributes to reduced profitability. To complicate matters even more, by offering quarterly “earnings guidance” (management’s best guess of how much the company will earn over the next three months), corporate executives essentially collude with investors in the pursuit of short-termism.
In sum, the short-termism of fund managers and corporate executives—reinforced by the short-term bias of our capital gains tax—is leading to investment behavior that compromises innovation, GDP growth, and job creation. As I will explain, short-termism also invites a broad array of corrupt behavior. I refer below to these twin threats to American capitalism as the innovation problem and the corruption problem.
The Innovation Problem
Myopic investment behavior by fund managers and corporate executives has been widely discussed by both business leaders and scholars for years. Due to the high level of computational complexities involved, few convincing calculations of the economic costs of investment myopia are available. This does not mean, however, that we do not have a long history of studies. Clayton Christensen presents one of the most insightful discussions of investment myopia and its effects on innovation in a November 4, 2012 New York Times article.
Asserting—correctly, we would all agree—that innovation is the engine of growth and prosperity in our economy, Christensen observes that executives and investors can invest in three basic types of innovation:
- Empowering innovations that transform complicated and costly products available to only a few folks into simpler, cheaper products available to the many—such as Ford’s Model T, IBM’s personal computers, online trading at Schwab, and cloud computing. Christensen observes that empowering innovations create jobs, because they require more and more people who can build, distribute, sell, and service these products.
- Sustaining innovations that replace old products with new models. Christensen cites the Toyota Prius as a good example. He writes, “It is most likely that when a Prius is sold, that same customer does not also buy a Camry. There is a zero-sum aspect to sustaining innovations. While they replace yesterday’s products with today’s products and help keep our economy vibrant, they have only a neutral effect on economic activity.”
- Efficiency innovations that reduce the cost of making and distributing products and services—such as with minimills in steel and Geico in online insurance underwriting. Christensen observes, “Taken together, efficiency innovations reduce the number of jobs through streamlining. But they also serve to release capital for redeployment.”
The core of Christensen’s argument is that the three innovations ideally operate in virtuous cycle. Empowering innovations create new consumption and economic growth. “As long as empowering innovations create more jobs than efficiency innovations eliminate, and efficiency innovations liberate capital that can be invested back into empowering innovations, these three innovations can keep recessions at bay” and combine into a recurring cycle of innovation and economic growth.
He then observes that America has operated this way for most of the past 150 years, but that trend data suggests that our economic machine is now out of balance.
Using data prepared by McKinsey & Co, Christensen observes that “in the seven recoveries from recession between 1948 and 1981 the economy returned to its prerecession employment peak in about six months. . . . In the last three recoveries, this has not been the case. The 1990 recession took 15 months, not the typical six to reach prerecession peaks of economic performance. After the 2001 recession, it took 39 months to get out of the valley. Today, we have grinding for 60 months to reach prerecession levels, and it is not clear when or how we are going to get there.”
What this suggests to Christensen is that “efficiency innovations are liberating capital, but that this capital is being reinvested in more efficiency innovations rather than in empowering innovations, which can power us through economic downturns.”
It is of course difficult to unravel all the causes of this shift. The excess focus on short-term earnings and stock price referred to above most likely plays a significant role. But so, too, Christensen argues, is the wide spread adoption of financial performance metrics stressing the efficient use of capital in an age of relatively abundant capital. Metrics like return on investment (ROI), return on net assets (RONA), or return on capital employed (ROCE) stress capital efficiency rather than innovation capacity. And, of course, when the internal rate of return (IRR) metric is used, the return naturally goes up as the time horizon comes down. When companies plan investments and keep score according to efficiency measures, they inevitably invite investment decisions where uncertain, empowering innovations requiring long lead times for development are sacrificed for more certain efficiency innovations requiring much shorter time horizons for profitable results.
A few publicly owned companies—such as Intel, Amazon, and Apple—have managed to resist this short-term bias and investment myopia, even when disappointing earnings have battered their stock prices. However, the commitment of many public companies to empowering innovations has weakened in recent decades—even broken down—as corporate executives have become increasingly reliant on efficiency-based performance measures and as fund managers and executives alike have become preoccupied with near term earnings. Knowing that beating the next quarter’s earnings expectations by as little as a penny can boost a company’s stock price, or avoid a sharp price decline, executives have strong incentives to curb or minimize long-term investments in empowering technologies.
The Corruption Problem
Short-termism not only compromises long-term investments in empowering innovation. It also invites institutional corruption, which refers to institutionally supported behavior that, while not necessarily unlawful, erodes public trust and undermines an offending company’s espoused goals and other legitimate processes.
In the world of business, institutional corruption takes many forms. Apart from clearly prosecutable crimes—which is not what I am discussing here—the most pernicious forms of institutional corruption involve:
- gaming of society’s rules and regulations (as in skirting accounting and SEC rules in the management and reporting of earnings),
- tolerating conflicts of interest (as between investment banks and their clients in the design and marketing of risky investment products), and
- violating accepted norms of fairness (as in matters of excessive employee compensation).
Just as American capitalism needs empowering innovations to fulfill its promise, so, too, does it require public trust to endure. The mix of behaviors that define institutional corruption has already sent public trust in business to a new low in recent years. According to the Edelman Trust Barometer, an annual global survey, just 46 percent of “informed” Americans in 2011 said that they trusted U.S. business, down from 54 percent in 2010. These results place public trust in the private sector in the United States far behind that in Brazil, India, and China—and within 5 points of Russia!
What’s more, only 25 percent of informed Americans surveyed by Edelman in 2011 trusted bankers to do the right thing—down from 71 percent in 2008. According to a more recent CBS/New York Times poll, 74 percent of the public have “not much” or “none at all” confidence in bankers and financial institutions. The Pew Research Center also reports that 68 percent of their survey respondents felt that bankers and other financial institutions were having a negative effect on the way things are going in the country today.
The link between short-termism and trust-destroying institutional behavior is fairly intuitive: the shorter the time period for measuring individual and organizational performance, and the larger the rewards and penalties directly tied to these short-term measures, and, finally, the weaker the accountability for long-term adverse consequences, the greater the incentive for executives to seek short-term rewards by gaming society’s rules, tolerating conflicts of interest, and violating common decency or other standards of fair conduct. Similarly, when financial rewards based on the short-term performance of a transaction or business strategy dwarf the personal risks involved, a huge incentive is created for executives to pursue immediate personal gain—even when the their companies’ reputation is placed at risk.
While we do not claim that large, short-term incentives inevitably lead to corrupt behavior, it is fairly clear that an important relationship exists between financial incentives and corrupt behavior.
This intuitive argument may ring true to those familiar with the perverse systems for measuring and rewarding performance and the sloppy board oversight that led to over two dozen corporate governance scandals in the first decade of the 21st century. While much of the executive behavior in these companies involved prosecutable fraud, some of the most troublesome and wide-spread forms of corruption were not incontestably illegal. This was certainly the case with Enron.
After 1997, its first year of declining profitability, Enron embarked on a relentless strategy of gaming accounting and SEC rules, including the use of off-balance-sheet partnerships to inflate quarterly and annual earnings, the reorganization of business structures to obfuscate line-of-business reporting, and the use of accounting techniques for asset sales to boost reported current earnings. Other such games include the use of “prepay” transactions to disguise the firm’s true end-of-year debt, and the use of opaque financial disclosure to support the company’s stock price. Reasonable parties differ on whether each instance of regulatory influence and devious behavior was actually unlawful, but no convictions were delivered on any of these specific maneuvers. However, the company’s propensity to misrepresent and cheat clearly rose with the stakes involved in missing short-term earnings and expectations for cash flow.
The Sarbanes-Oxley Act, passed in 2002 after the collapse of Enron, was meant to eliminate Enron-type corruption. The jury is out on its general effectiveness, but it is pretty clear that the prescribed governance reforms were not sufficient to contain institutional corruption in the finance industry—in mortgage banks, investment banks, and credit-rating agencies involved in writing, securitizing, and grading all those subprime mortgages that led to the 2008 financial crisis. Whatever the role of criminal intent in these cases, the short-term financial rewards were large enough to dwarf the risks of prosecution. Similarly, a lack of long-term consequences—such as “clawbacks” of executive bonuses when reported gains proved unsustainable—made corruption more tempting.
As one more indication of the relationship between short-term financial incentives and corrupt behavior, there is a long history of research—at the Harvard Business School and elsewhere—on the adverse side effects of short-term time horizons and financial incentives for executives. Most recently, this line of research has shown how executive pay practices—annual bonus schemes and other short-term financial incentives—have had a corrupting influence on accounting choices and efforts to manage corporate earnings and boost stock prices artificially. In addition to this accounting-based literature, there is a substantial body of economic and legal commentary supporting the notion that compensation based on short-term employment contracts, stock-based compensation, and maximization of stock price is a key driver of short-termism and institutional corruption.
What Can Be Done?
Dealing with the decline in empowering innovations and the rise of institutional corruption is complicated. Still, we offer several ideas to seed a productive discussion.
The most widely discussed in the business community involve more effective board leadership in promoting longer time horizons for strategic plans and greater investments in empowering innovations; in designing more sensible compensation practices for senior executives that de-emphasize short-term, efficiency-based performance metrics; in demanding increased personal accountability among executives for the long-term prospects of their company in the form of look-backs and claw-backs; and mandating that senior executives (and directors, too) have “skin in the game”—meaning a significant portion of their wealth invested in the long-term success of the company.
The less widely discussed and potentially the most powerful remedy involves changing the capital gains tax rate and qualifying holding period in ways that curb the curse of short-termism, provide strong incentives for empowering innovation, and help shut down institutionally-supported corruption.
For years the conversation about our capital gains tax has correctly addressed the tradeoff between tax revenues on the one hand and savings, investment, entrepreneurial activity, GDP growth, and jobs on the other. But far less attention has been paid to how a significantly lower (or zero) capital gains tax rate on truly long-term investments (say 60 months or longer) would affect the investment behavior of fund managers and corporate executives and the seemingly ubiquitous gaming of society’s legislated rules.
A lower, super-long term capital gains tax rate—with the rate descending to zero over a 60 month holding period—would make it more profitable for executives and taxable investors to hold stock (and stock options) for a longer time period. This, in turn, would automatically extend the time horizon of fund managers and corporate executives, thereby helping to moderate the speculative culture of Wall Street and curb myopic investment behavior and institutional corruption.
As long as savings, investment, entrepreneurial activity, and GDP growth are not compromised, eliminating the short-term bias in our current capital gains tax regime should receive broad public support. Past research by economists Allen Sinai, Paul Evans, and others suggests that these conditions could well hold.
For example, the most recent study by Allen Sinai, president of Decision Economics, which was reported in the Wall Street Journal on September 21, 2010, finds that “a reduction in the capital gains tax rate to 5 percent from 15 percent raises real GDP by 0.2 percentage points per year, lowers the unemployment rate by 0.2 percentage points per year, and increases nonfarm payroll jobs by 711,000 a year. Productivity growth improves 0.3 percentage points a year.” Sinai also reported that reducing the capital gains tax to zero would have even bigger effects—including an increase in R&D spending by close to $8 billion over five years—and end up costing the federal government less than the initial, static cost of the tax reduction.
Macro-economic modeling exercises, such as Sinai’s macro-economic model of the U.S. economy, always entail a myriad of assumptions about, for example, how people would respond to changes in the return to savings and how investors would respond to changes in the cost of capital. Such assumptions and various methodological choices inevitably invite controversy. But the Sinai model nevertheless demonstrates the productive possibilities of a changed capital gains tax policy.
Even if a descending capital gains tax rate were shown to be neutral with respect to revenue and GDP growth, it would certainly be an attractive reform because of its positive effects on the time horizons of fund managers and corporate executives.
During President Obama’s first term, both the White House and many members of Congress were apparently convinced of the potentially positive economic effects of a lower capital gains tax rate. A temporary provision in the Small Business Jobs Act, signed by the President in September 2010, eliminated capital gains taxes on investments held by certain small businesses for more than five years. While this provision has now expired, the Business Roundtable Institute for Corporate Ethics and the Aspen Institute both support an increased tax differential between long-term and short-term holding periods for assets as a way for encouraging long-term share ownership and investment horizons.
Since a large percentage of investors such as pension plans, individual retirement accounts, foundations, and endowments are tax-exempt entities, there is a chance that applying a zero, or near-zero, tax rate to super-long-term (five years or longer) capital gains on all corporations might not have its intended effects. However, my best guess is that because most institutional investors invest large amounts in mutual funds, hedge funds, and other private equity funds, lengthening the time horizons of these financial intermediaries could also extend the time horizons of tax-exempt investors as well.
Another question is whether a zero tax on super-long-term capital gains would create a perverse incentive for firms to keep capital locked up in a plateaued investment. I would argue that a practical solution to the “trapped capital” possibility is scaling the capital gains tax, so that it gradually declines to zero over a five-year period. This structure would mean that the trade-offs between holding and selling an asset would be less stark in the middle years.
Such a descending scale could also mitigate the “Warren Buffet problem,” wherein some wealthy individuals may decide to take a large proportion of their income in “undertaxed” capital gains, and thus end up paying proportionally less than most taxpayers. Under such a scale, those who live off capital gains would still be paying taxes on all but the longest-term capital gains.
To mollify perceptions that a lower capital gains tax benefits the “rich” more than the “poor,” any change in the capital gains tax regime along the lines suggested here would need to be accompanied by a tandem requirement of a minimum tax for citizens with income above an agreed-upon level. For similar reasons, the tax rate on dividends or unearned income, which is currently tied to the capital gains tax rate, would most probably need to be severed from capital gains and taxed at ordinary income tax rates (another radical move).
At the end of the day, whatever the principles guiding future tax reform—simplifying the tax code, broadening the tax base, raising tax revenues, maintaining a progressive income tax, ensuring an internationally competitive corporate tax rate, or promoting economic growth—we need to seriously review the capital gains tax. This tax directly influences—both positively and negatively—the level of empowering innovations and trust-destroying corruption in our economy. The implications of how this tax is designed and administered are profound for our system of economic governance.