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Hillary Clinton's capital gains tax reform, explained

I want to tax investment income *this much.*
I want to tax investment income *this much.*
Scott Olson/Getty Images

As part of her plan to reduce the impact of short-term thinking on corporate America, Hillary Clinton is proposing a revamp of how investment income is taxed in America. Right now, the tax code distinguished between a short-term investment held for less than a year and a long-term investment held for longer than that. She wants to replace that with a different system, featuring a six-year sliding scale of rates to give genuinely long-term investors a leg up.

What's a capital gain? How is it taxed?

A capital gain is income that a person makes from investment. If you buy a house for $200,000 and sell it 10 years later for $250,000, you have scored a $50,000 capital gain. The current tax code largely exempts capital gains earned buying and selling owner-occupied houses, so the debate over capital gains taxation generally focuses on capital gains secured by buying and selling stocks, bonds, and other financial assets.

Right now the tax code distinguishes between short-term capital gains and long-term capital gains. A short-term capital gain is defined as a gain on an asset that you owned for less than a year, while a long-term capital gain is defined as a gain on an asset that you owned for longer than a year. Short-term capital gains are taxed at the same rate as wage or salary income, but long-term capital gains are taxed at a lower rate.

In other words, the current tax code already features lower tax rates for income derived from long-term capital gains than for income derived from other sources. Clinton is proposing, essentially, to extend the logic of the current system, not to replace it with a whole new logic.

Why is capital gains income taxed at a lower rate?

There are three big explanations for the current system — a cynical one, one grounded in political rhetoric, and an economics-y one:

  • The cynical take is that capital gains income receives a tax preference because the vast majority of capital gains income is earned by rich people. And not just any old kind of rich person. A movie star or LeBron James is still mostly working for a living. It takes a classy kind of rich person to have big stock market earnings.
  • The rhetorical reason typically offered is that, as the American Enterprise Institute's James Pethokoukis says, capital gains taxes are a "double tax." The idea is that first Mr. Richpants gets paid a salary and pays taxes on it. Then he takes some of his after-tax dollars and invests them in the stock market. Then when he sells his stock, he is "taxed again" on his earnings in a way that would not have happened had he spent the money on a boat rather than invested it in the stock market.
  • The economics-y reason is a result in theoretical macroeconomics stemming from work by Christophe Chamley and Kenneth Judd that shows that under appropriate assumptions, the socially optimal level of investment taxation is zero. The result involves a lot of math, but the intuitive idea is that the less you tax investments in capital goods, the more capital goods you get. And the more capital goods you have, the higher your wages will be. Consequently, even people who derive all their income from wages benefit in the long run from not taxing capital income. Garrett Jones has a slightly longer explanation featuring light math if you are interested.

What is Hillary Clinton proposing to do?

Her campaign has not yet released a fully-fleshed out plan, but they say she wants to make two changes. One is to push the current one-year definition of short-term capital gains out to two-years.

The second is that she doesn't want to give every investment held for longer than two years equal treatment. Instead, she wants a sliding scale of rates over a multi-year period so that you would need to hold an investment for a full six years to qualify for the discount rate.

Is the case for low capital taxation correct?

Needless to say, people disagree. In practice, there appears to be very strong political consensus around preferential treatment for investment income. Even very liberal members of Congress, for example, do not propose ending the exemption of capital gains income from the payroll tax that finances Social Security. Nor do liberal members of Congress propose to end the exemption of profits made by selling owner-occupied homes from capital gains taxation. Countries all around the world feature some form of preferential treatment of investment income, and despite the partisan controversies around the capital gains tax rate nobody in American politics is actually proposing to do away entirely with our own preferential treatment.

That said, as is typical with highly theoretical results in macroeconomics, there are massive challenges in saying whether the Chamley-Judd construct applies in a meaningful way to the actual policy choice at hand. As economist Matthew Martin writes, "Any graduate macro text will show you some of the ways in which Chamley-Judd assumptions are violated in reality, producing a non-zero optimal tax rate."

Empirical studies also struggle to confirm the idea that tax rates on investment income are an important driver of real investment activity. A recent, statistically sophisticated study of the 2003 dividend tax cut by Danny Yagan, for example, finds that "the tax cut caused zero change in corporate investment."

Note, however, that even if the optimal tax rate for capital gains isn't zero it might still be optimal to have a lower rate on investment income than on wage income.

Why is Hillary Clinton proposing this?

Rather typically for Clinton as a political actor, what she seems to be zeroing in on is a clever way to build consensus between competing factions of wonks.

  • By raising tax rates on medium-term capital gains, Clinton will raise a bunch of tax revenue, and she will raise it overwhelmingly from high-income individuals. These are key demands of liberals, who are hungry for social spending and redistribution.
  • At the same time, by maintaining the low rate on longer-term capital gains, Clinton avoids a root-and-branch challenge to the principle of a tax preference for investment.
  • Clinton has been critical lately of what she calls "quarterly capitalism" and the idea that real world investment activity is being excessively influenced by short-term stock market fluctuations and earnings targets. Her altered tax system would make it more lucrative to be a patient investor than an impatient one, which might help generate an overall more patient climate on Wall Street — boosting corporate investment and fostering more long-term thinking.

A serious venture capitalist, for example, would almost certainly find himself still qualifying for the preferential rate. But a corporate raider looking to buy a company, strip assets, improve quarterly results, and then exit as quickly as possible would not.

Expect the campaign to front-load this short-term versus long-term issue, since it's emerging as a key theme for Clinton overall. But also note that in theory one could accomplish the same thing with a tax cut. Take today's rate for investments held over one year and apply it to investments held for one to three years. Take longer-term investments and apply a new lower rate to them. This would address the short-termism concern, while also addressing the GOP's opposition to higher taxes.

Clinton won't offer a proposal along those lines because for her, tax revenue and tax system progressivity are at least as important as the short-term versus long-term issue.