The Higher Rate for Short-Term Capital Gains – a Questionable Policy Choice

June 26, 2013

One curious aspect of capital taxation is the relatively higher rate on short-term capital gains for individual filers. For all tax brackets, the tax rate is higher for gains realized in under one year. For people in the 10% or 15% tax brackets on ordinary income, including short term gains, the long term gain rate is 0%. For people in the 25%, 28%, 33%, and 35% brackets, the long term rate is 15%. In the 39.6% bracket, it jumps to 20%. In the five upper brackets the long term rate is about half the short term rate on average.

Although this policy of having a higher rate on short term gains than long term gains has a substantial effect on behavior, there is little literature concerning it. Most ordinary savers care more about the long-term capital gains tax rate, because they are in the market for the long haul and do not churn their holdings. They routinely hold their assets for at least one year and pay the long-term rate on gains. Naturally, the long-term rate is more relevant to them.

Nonetheless, the policy on short-term capital gains deserves some examination. Clearly, the system is designed to discourage individual investors from realizing capital gains on investments held less than one year. But does this accomplish a useful objective?

The policy almost certainly has no effect on the market prices of stocks. Stock prices are not set by individual investors buying or selling handfuls of shares. Prices are set by big moves by large investors, like pension funds or investment banks. Individual investors are just along for the ride.

Is the policy intended for the benefit of the individuals themselves? Perhaps without the differing rates for short-term and long-term capital gains, investors would trade too frequently. There is indeed substantial literature to suggest that day trading is a poor strategy for most investors – but if the goal of the policy is to discourage day trading, then the time threshold for “short term” capital gains should probably be much shorter (24 hours, perhaps?). That is tongue in cheek, but there is also a serious normative question of whether the tax code should be used to punish people who make slightly suboptimal investment choices.

There are some real costs to consider when the tax code discourages trading. Some trades made by individual investors are legitimate attempts to rebalance their portfolios, or to respond to breaking news about their investments that change their prospects. An imbalanced portfolio subjects an investor to an idiosyncratic risk that can be removed through appropriate trades. Leaving a stock that has ceased being appropriate for one’s situation is a wise move. For all we know, the policy could discourage as many good trades as bad ones.

A further reason to question the two-tiered rate system for capital gains is that it’s redundant. Even a single rate for all capital gains discourages closing out a position before a year has elapsed. Selling a position immediately forces people to pay the capital gains tax up front, while holding the position for multiple years allows people to defer the tax liability into the future.

The usual reason for imposing an ordinary income tax rate on short term gains is to tax investors and dealers in securities and futures contracts for whom the making of a market in commodities and stocks, and the speculation in their short-term price movements, is their ordinary business, such that the gains are, in fact, their ordinary income. That consideration does not apply to ordinary savers. Distinguishing between the two types of traders could be accomplished with a shorter holding period or some form of registration of professional traders.

On the whole, it looks like current policy adds an additional layer of complexity to the tax code without evidence that it improves welfare.


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