Simpler idea---tax capital gains as normal income, in all cases, applying appropriate bracket rate.

In some (many?) situations, hedge funds are large enough to move markets. This condition gives them surprisingly powerful levers to manage their own performance in the short term.

Given that temptation, it seems logical to consider their managers' compensation accordingly. (As in, the compensation needs to be adjusted for long term performance...)

In response to the very good idea in Tom's comment:

Simpler idea---tax capital gains as normal income, in all cases, applying appropriate bracket rate.

I have always wondered about *when* to tax capital gains. When should transactions be taxable? I used to think that "keeping it in the capital market" should be nontaxable, as in moving money from one investment vehicle to another. Taking money out of the market always seemed to be a good time to tax a transaction. And I've always thought that tax rate is exactly income like any other.

There another interesting question though which is, "What constitutes taking money out of the market?" And equally importantly in my mind, should there be differential tax treatment for moving capital between U.S. and non-U.S. markets?

Disclaimer: I am a software geek, not an economist. My views on this stuff tend to come from a fairly naive view of markets. And I think that real wealth-generating work should be rewarded at least as well as successful investment management, at least from a tax-treatment perspective.

We tax cap gains when they're realized--ie, when someone sells an asset and makes a profit, we tax the profit.  That seems to me to be the right time--pretty intuitive.

In most of the tax code when the way you earn your living is taxed as ordinary income, even if others might be able to treat the income a capital gains. Why hedge fund managers should have a special benefit is very strange.

However, keeping capital gains rates and dividend rates low, and attempting to avoid double taxation of dividends, seem like a good idea to encourage capital formation and preventing capital from leaving the U.S. It is the case that capital is crucial to the expansion of labor.

Daniel A. Greenbaum

I think it makes sense to tax dividends as ordinary income to individuals. If we're worried about double taxation of dividends (and I'm not sure I am), I think we should address it on the corporate tax side, not the individual side. Maybe dividends paid should be tax deductible on the corporate side?

Doesn't this also raise a broader question of the taxation of closely-held private businesses? Seems to me like a lot of small (and big) business owners have a lot of ways of avoiding taxes. Whether it's the hedge fund partner who gets to treat what seems like income as capital gains (cutting his tax rate in half) or the plumber who writes off his car as a business expense, business owners get a lot of tax breaks that ordinary wage earners can't get.

I would agree with your point about dividends at the corporate level. One of things that would be desired is for corporations to expand their capital base with equity and less with debt. While there are endless theories about the optimum mix equity to debt when the economy turns down companies loaded with debt tend to unload workers or even go out of business.

Daniel A. Greenbaum

My 912th (or is it 913th?) confession of ignorance around here...

<blush>What's a hedge fund?  How does it work?</blush>

I profoundly hope I'm not the only ignoramus who doesn't understand this.  :-D

aMike

That's a huge difference -- 15% at capital gains tax rate vs. 35% at the income tax rate.

It's a high stakes poker game, except slightly less regulated.

Basically, I'd describe them as private investment companies (private, as in not publically listed on a stock exchange) that have a few identifiable characteristics:

--you need a lot of dough to join;

--they tend to use complicated investment techniques to hedge their bets (heads, they win; tails, they win).

--they're lightly regulated relative to public investment companies.

You've brought up an important topic, Jared, but I'm afraid most people are quite clueless as to what is being discussed. I don't usually dump one of my essays on this crowd but I think the following might be helpful to those who are shaking their heads at the references that are being made, suspecting that they are again being had by Wall Street but can't quite put their fingers on why:

The supreme importance of investment is understood by all economists. Without it, long-run improvements in economic welfare are impossible. We want investment to occur whenever it is likely to improve our lives. Unfortunately, very few of the tax policy proposals touted in Congress as "investment-friendly" are likely to do anything at all to increase desirable investment in the United States’ economy. To understand the flaws in these proposals we first need to understand the difference between financial investments and real economic investments.

Economic investments---the kind that actually end up improving the economic welfare of a population---involve purchases of capital goods or other economic resources that are used to either produce more capital goods or more final goods that consumers find desirable. In other words, they either increase output or expand the supply-side's productive capacity. This happens whenever firms purchase machinery/equipment to improve productive efficiency or when they spend money on the construction of new stores or factories or on the salaries of new employees. However, not all firm expenditures are economic investments, e.g., money spent by firms on advertising that either (a) misleads consumers or (b) does nothing to help them with their purchasing decisions.

Financial investments---are purchases or commitments of money that provide the "investor" with an income stream. Saving money is a financial investment because it provides interest income; purchases of assets can be financial investments if they eventually provide a capital gain. Economic investments made by firms are usually also financial investments because they generate income that exceeds their cost. The economic investments made by governments that improve infrastructure or human capital are not financial investments because they do not provide the government with an income stream.

Some financial investments are also economic investments, but many of them are not. The purchase of a piece of land, for example, is a financial investment if it appreciates in value over time, but it is not an economic investment if it just sits there, undeveloped. Purchases of stocks in secondary markets (e.g., NYSE, NASDAQ) are clearly financial investments if the stocks appreciate in value, but they are not economic investments because they involve nothing more than exchanges of titles of ownership of already existing assets. They do not typically put any money into the hands of firm managers that could be used for economic investments. That normally happens only when stocks are first sold to underwriters, prior to an initial public offering.

Supply-Side theorists have taken advantage of the impreciseness of the word investment to craft tax policy proposals that sound as though they are beneficial to the economy, but actually are not. The famous Capital Gains Tax Cut, for example, is frequently promoted as an incentive that would stimulate 'investment.' Unfortunately, the only 'investment' that such a tax cut is likely to stimulate is increased financial investment in stocks and other real assets. One financial investor hands money over to another financial investor for a piece of paper. Very little if any of the money involved in these transactions ends up being spent on capital goods that would increase output or the productive capacity of the economy.

When do firms need special incentives to motivate them to invest in new capital goods? The answer is never. In modern market economies, competition provides firm managers with the most powerful motivation to continually invest that they will ever need: fear. They ultimately face both the fear of bankruptcy and the fear of lost opportunity. If your competition lowers its costs by investing in new equipment, or improves the appeal of its products by incorporating new innovations, then you’d better do the same or you will soon find yourself driven out of business. With only a few exceptions, additional government-provided financial incentives are nothing more than an unnecessary waste of tax dollars.

Entrepreneurs do not need special additional incentives provided by the government to encourage them to assume the risks of creating a new business. True risk takers believe that their ideas will succeed in the market and have so much of their identities invested in them, they really don’t care if they receive any return at all on their invested time and money, sometimes for several years, as long as they have hope of eventual success. The problem for them is not that they lack motivation; it's that they can't find someone who is willing to provide them with a loan that banks, venture capitalists, and angel investors find too risky.

In confronting this situation, Congress has a couple of options. It can choose to do nothing and simply allow the marketplace to reward firms-that-make-wise-investments with the market share of firms-that-do-not. The other option would be for lawmakers to help entrepreneurs [and established 'too-risky' firms] to obtain the funding they need in the hope that they might then be competitive with better established firms. The rational way to do this would be to provide these marginal firms with targeted investment tax credits or perhaps with guarantees on private loans.

These kinds of initiatives would put the money directly into the hands of those who will be investing the money. Compare this to the insane idea of giving tremendous amounts of extra disposable dollars to wealthy savers in the hope that their extra savings might somehow make their way into the hands of true economic investors when private banks have already rejected their borrowing plans as too risky. Very little, if any, of those billions of dollars would actually end up helping needy entrepreneurs and firm managers.

I hope this helps...

Especially when you consider that fortunes are made in fractional percentages of interest and share value.

Since the essence of real business investment is sinking money into productive capacity over a long term ... one way is to reward financial accumulation that acts like real business investment, by staying put for the long term.

That is, "capital" gains would be limited to assets, whether real or financial, held for five years or more.

Gains on assets held for a shorter period of time, well, that's just income.

Because you invest in the fund, not the underlying stocks in the fund. So if you hold your fund shares for more than a year, that's a long term gain, the underlying securities don't determine what gains or losses you realize, that's the NAV of the fund shares.

thosethingswesay.blogspot.com

I agree, you could have a more progressive outlook for capital gains that would have the rate go down as the investment length climbed.

Why 1 year? It's a little arbitrary, I know. But, it does make some sense -- companies tend to give earnings guidance for 12 months forward. So, if a company is guiding you towards expectations for the next 12 months, it does seem fair to say that you're an investor and not a trader, if you're buying and holding for that 12 month period.

Certainly, if you take the mutual fund universe into account, 1 year does make you a long term investor. The average mutual fund turns over the stocks in its portfolio 3 times a year. The mutual funds are the biggest investors out there. If they're churning at 300%, then a 1 year horizon for an individual is pretty much "buy and hold."

BUT... and this is where you're damned right... 1 year is not really a long term time horizon in terms of financial planning. If we set tax rates to encourage investors to think in increments of 3-5-10-20 years, we would actually save them from having to even worry about those individual days when the Dow drops 500 points. We'd be encouraging healthy investing habits.

thosethingswesay.blogspot.com