Why You Should Love Higher Taxes

Never, ever, think about something else when you should be thinking about the power of incentives. -- Charlie Munger

Maybe you've heard this popular myth:

A major cause of the financial crisis was boneheaded Wall Street compensation packages unaligned with shareholder interests.

Before I can tell you why that story is so misleading, please ask yourself this:

Am I an investor, or am I a speculator?
During his recent visit to Fool HQ, business legend John Bogle argued that this is the very first question you must ask yourself.

The distinction is simple but powerful: Investors buy shares of businesses and prosper over time as the company grows profits. Speculators, on the other hand, trade wiggles on a stock chart, hoping to sell shares at a higher price to other speculators within a few quarters.

Back to the myth
Sadly, shortsighted compensation plans and business strategies are aligned with the time horizons of the vast majority of shareholders. After all, at year-end 2007 (the most recent statistical set), some 80% of shares were held by financial institutions. And the evidence shows that financial institutions are, by and large, speculators.

Given the explosion of mutual funds, 401(k)s, endowments, and the like, it makes sense that institutional ownership has steadily risen over the years. As institutional ownership has grown, however, the average holding period of stocks has shrunk:

Year

NYSE Turnover

Holding Period

2009 (year-to-date)

157%

8 months

2000

88%

14 months

1990

46%

26 months

1980

36%

33 months

1970

19%

63 months

1960

12%

100 months

Source: NYSE Group Factbook. Turnover = number of shares traded as a percentage of total shares outstanding.

It gets even worse when you look at the overall stock market, according to Bogle. Inclusive of exchange-traded funds, the overall market turned over at 284% in 2007. That means the average holding period for stocks and ETFs was four months!

OK, OK, but how does this speculative frenzy affect you?

Wall Street's very dirty secret
Simply put, when an institutional shareholder has a time horizon of four months, they should want management to pull out the stops right now to hit quarterly earnings targets. If they're not going to own the stock in five years, why would they concern themselves with the long-term effects of today's business decisions?

Consider the average holding period of these stocks in 2007 -- the year before the volatility-inducing financial meltdown:

Company

Holding Period

Bank of America (NYSE: BAC  )

9.4 months

AIG

9.3 months

Citigroup (NYSE: C  )

5.8 months

Morgan Stanley

5.0 months

Lehman Brothers

2.5 months

Sources: Yahoo! Finance; Capital IQ, a division of Standard & Poor's; and author's calculations. Turnover calculated as total yearly volume divided by average shares outstanding.

One appalling example
From 2000 until the collapse of the firm, former Lehman Brothers CEO Richard Fuld received approximately $350 million in total compensation. In part, he was rewarded for growing the company's earnings at an annual rate of 18% over that time frame … except that those returns were produced using 30-to-1 leverage on top of a shoddy asset base.

Since it would only take a roughly 3% decline in the value of Lehman's assets to render the firm insolvent, it seems as if Lehman operated with temporary gains in mind, but no thoughtful strategy for how to avoid blowing up. And on Sept. 14, 2008, it did, in the largest bankruptcy ever.

The shock of Lehman's failure froze credit markets, wrecked huge derivatives losses, and set off bank runs around the world. In just one month, the TED spread shot up to an all-time high. AIG needed to be rescued by taxpayers because of the billions it lost because of Lehman's collapse.

The run on Washington Mutual, which began the day of Lehman's collapse, led to the largest bank failure in U.S. history in mere weeks. One Wells Fargo senior economist estimated the employment fallout from Lehman's bankruptcy at 2 million job losses. Now, even strong companies unrelated to the financial industry are suffering from the economic fallout of this crisis -- Caterpillar (NYSE: CAT  ) and Google (Nasdaq: GOOG  ) , for example, have been forced to announce layoffs.

No one disputes that the outrageous risks taken at Lehman Brothers and similar institutions have had terrible effects on our economy. But consider this: Despite Lehman's epic collapse, it's probable that most shareholders benefited from Lehman's more than 200% rise over eight years. Refer back to the chart above -- the average holding period of Lehman stocks was less than three months!

Frankly, this upsets me. And I can't blame you if it makes you mad, too. The fact that a majority of business owners' interests are unaligned with the health of their own businesses runs completely counter to the well-being of our economy and the basic tenets of capitalism.

If capitalism is going to work, this ridiculousness needs to change.

Here's my plan
One market-oriented mechanism would be a tax increase on speculation, combined with a tax decrease on investing. If it became less profitable for institutional shareholders to speculate on short-term price movements, and more profitable to invest for the long term, their holding periods might increase, and they'd likely care more about the financial health and compensation structures of the businesses they own.

This could take the form of a graduated 60% speculation tax on stocks and equity-based derivatives held for less than one year, which tapered down to, say, 5% after a few years.

I'm not the only investor who has thought of such a plan. Warren Buffett (perhaps facetiously) once suggested a 100% short-term capital gains tax, while John Bogle has advocated a 50% rate.

As someone who feels the economic impact of this crisis, you should love a higher tax on speculation, because it would align institutional shareholders with the long-term health of the companies they own. Without such a shift in incentives, they would have limited reason to demand responsible management, and a crisis like this one would be more likely happen again.

The silver lining …
To be fair, not every corporation fits the Lehman mold. Berkshire Hathaway's (NYSE: BRK-A  ) shareholders are owners for more than 30 years on average; they must be happy with Warren Buffett's relatively meager compensation, large stock ownership, and long-term focus. Whole Foods' (Nasdaq: WFMI  ) John Mackey, Microsoft's (Nasdaq: MSFT  ) Steve Ballmer, and Costco's Jim Sinegal have compensation structures that look much more like Buffett's than many of their CEO counterparts .

Just as we saw a number of disasters in the past year, I expect -- and history confirms -- that we will begin to see other companies benefit from their missteps. With stocks so cheap, making money now becomes a matter of examining every facet of a company -- including the competency of its management team, rewards and incentives, business strategy, and market environment.

Ilan Moscovitz owns shares of Google, Berkshire Hathaway, and Whole Foods. Microsoft, Costco, and Berkshire are Inside Value recommendations. Costco, Whole Foods, and Berkshire are Stock Advisor selections. Google is a Rule Breakers pick. The Fool owns shares of Berkshire Hathaway. The Motley Fool is investors writing for investors.


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  • Report this Comment On April 17, 2009, at 5:24 PM, Melaschasm wrote:

    That is an interesting idea. Another way to punish short term investment would be a 1% tax on each transaction. That would require an expectation of greater benefit to make a transaction, and lengthen the time of ownership needed to recover the 1% transaction tax.

  • Report this Comment On April 17, 2009, at 5:34 PM, TMFTomGardner wrote:

    This article should be re-published and re-printed in many places. You could generate productive taxes, setting tolls in the right places (speculation) and reducing or removing them from the wrong places (ownership/investment). Well said, Ilan.

  • Report this Comment On April 17, 2009, at 5:47 PM, ctangus wrote:

    Great idea! It'd also reduce volatility.

  • Report this Comment On April 17, 2009, at 5:53 PM, stan8331 wrote:

    I've been thinking for some time that we ought to look at doing something to enhance the treatment of longer-term capital gains. Having one year as the only finish line seems counter-productive. Maybe add lower rate tiers for three years, five years, etc?

    I would also be in favor of some sort of small tax increase on short-term transactions. You wouldn't want to overdo it - penalizing sales too much could also end up encouraging irresponsible corporate behavior. We do need to do something, though. The problem described in this article is very real.

  • Report this Comment On April 17, 2009, at 6:08 PM, TMFMmbop wrote:

    I think Ilan's piece is very well done, but someone has to play devil's advocate...

    One negative effect of such a policy change is that we would see reduced liquidity, which could mean lower valuations and less incentive for companies to actually tap the public markets in the first place. And I tend to think having companies public is a good thing.

    Second, a tax would be unable to differentiate between a speculator and someone who may have just had a family emergency or some such as needs to take money out of the market.

    Third, it could make the markets less efficient since fast institutional money is often what clears up valuation discrepancies.

    Fourth, what are the implications for short selling? I think shorts are one of the reasons are market finds true value over time, but those are generally short-term trades.

    In the end, I don't think the solution is to punish the short-term investor with higher taxes, but rather reward the long-term investor with lower taxes (on cap gains or dividends or deductible transaction costs or some such).

    Tim

  • Report this Comment On April 17, 2009, at 6:21 PM, alvin wrote:

    nice piece. However since most people out ther are speculators, I doubt anything like this plan would ever be approved.

  • Report this Comment On April 17, 2009, at 6:27 PM, deidreeast wrote:

    Sometimes, however, investors need access to their funds for emergencies or participate in employee stock purchase plans where their money doesn't punch the time clock until the shares are purchased (at times, extending the requisite effective holding period to qualify for long-term cap gains treatment from 1 year to 1.5 years—in this case, when shares are purchased twice a year).

    I am not in favor of taxes to control behavior. Taxes should be used solely to fund the necessary functions of government, nothing more. It's the Libertarian in me coming out.

    The companies themselves could institute dividend programs that reward long-term investors, requiring a longer holding period before a shareholder is eligible for dividends and then a scaled increase relative to holding time up to some max. For example, shares could be eligible after being held for six months. For example, a company could pay out $0.25/sh for shares held one year, $0.50/sh for shares held two years, and $0.75/sh for shares held three or more years.

    If the companies see an advantage to having mostly long-term investors, they will figure a way to promote that behavior.

    One caveat: Irresponsible companies must be allowed to fail. If they are "too big to fail," I do believe we have mechanisms in place to deal with monopolies before they get to that point.

  • Report this Comment On April 17, 2009, at 7:07 PM, mythshakr wrote:

    The "speculators" will tell you you are plugging up the safety valve on the hot water heater. The corollary is restricting the ability to sell now if you need to. If you are in that situation then you need to rethink you asset allocation because you are above your risk tolerance.

    If there has been one lesson learned this past year it is that that the speculators love to prey on the panic-stricken.

    I would support a 90% tax on gains of instruments held less than 24 hours, 70% if held less than one week, 50% if held less than one month, 30% for less than 6 months and ordinary income between 6 months and 1 year. Particularly for institutions because of the greater influence they have on the market trends.

    Where would Lehman be today if something like this had been in place to make a disincentive of such short term thinking.

  • Report this Comment On April 17, 2009, at 7:26 PM, max888 wrote:

    We had a transaction tax of 0.20% for every equity transaction during the crash of 1929. So, a tax on speculation is obviously not the solution.

    Furthermore, we currently have the most liquid and attractive stock market in the world. What do you think will happen if we enact your additional taxes on top of the ones we already have? People will take their capital and move it to foreign markets that don't penalize traders. All of a sudden you will end of with a market that is much less liquid and that has much bigger spread between bid and ask prices. This would make it much more expensive for everyone, including investors.

    This is a very short sighted proposal with no apparent regard for the fact that it did not help us during the 1929 crash.

  • Report this Comment On April 17, 2009, at 7:49 PM, xetn wrote:

    I think that is a really stupid idea. No tax increase of any kind is a good idea. If you disagree with a company's compensation plan, don't put your money there. If you don't like a company's business model, don't invest. In other words, do your homework before risking your money. But the best advise is to let the free market (if only there was one) work, no government intervention of any kind, no bailouts, no government make-work projects. All government spending takes money out of productive uses and transfers it to non-productive uses. Take military spending, part of it is used to make bombs, a one-use product. What is productive about that?

    Every thing that the previous and current administrations did/are doing is a repeat of the great depression, and that was a disaster for the country, the economy, and the world.

  • Report this Comment On April 17, 2009, at 8:03 PM, iammainstreet wrote:

    Too many people think if regulations and the tax code could just manipulate the mechanics of the markets, it would make the markets go up and they could finally make money when in fact it would suppress the value of the markets which would be the least of the damage done. Studies indicate hundreds of thousands of jobs would be lost. The financial markets would move overseas. Watch US stocks flee and list mostly on foreign exchanges. That's what happened to Sweden.

    Does anyone know about the extreme bubble and the biggest crash ever of 1929, almost 90% drop in a couple years? There had been a transaction tax on stock since 1914 through 1966 that prohibited short term trading.

    Canadian government did an extensive study on such a proposal: Parliamentary Research Branch (PRB) of the Library of Parliament works exclusively for Parliament conducting research and providing analysis and policy advice to Members of the Senate and House of Commons and to parliamentary committees on a non-partisan and confidential basis:

    Conclusion: "Sweden, on the other hand, appears to be a classic example of an experiment gone wrong, while Germany, like many other countries, has decided that the costs outweigh any benefits from this type of tax."

    Some government studies links:

    http://www.parl.gc.ca/information/library/PRBpubs/bp418-e.ht...

    http://www.ibo.nyc.ny.us/iboreports/stocktransfertax.pdf

    http://siteresources.worldbank.org/DEC/Resources/23661_chap_...

  • Report this Comment On April 17, 2009, at 8:09 PM, catoismymotor wrote:

    I would rather not pay any more out in taxes than I already do. I like the idea of being encouraged with a carrot over punishment with a kick. How about a tax break for those that hold onto their investments? It could be a tiered system; if you hold them for three, five, ten, twenty years you would qualify for an amount of money as a reward. That amount would be equal to a percentage of your total contribution to your retirement plan(s). If things worked well enough it might be enough to help you make up much of the difference in what you pay annually in income taxes.

  • Report this Comment On April 17, 2009, at 10:55 PM, Guthree wrote:

    Fantastic idea. Absolutely logical.

    The stock market speculators need to get the heck out of the way of our businesses.

  • Report this Comment On April 17, 2009, at 11:09 PM, recmon wrote:

    more taxes to penalize any investor is dumb. I think investors have been penalized enough and it wasnt due to day traders... it was due to lies and crooks that need to go to jail. People say we should not put our politicians in jail because it makes our country look bad, I believe it makes our country look bad that we dont jail those who manipulate the markets and take advantage of our markets and investors. I seen it many times by both senator Dodd and Barnie Frank trying to scare and effectively rattle the markets with what they say. The problem isnt with investors, its with special interest groups taking control of our country and politics. The plans they are putting in effect where made back in 2005, the uptick rule was changed during Bill Clintons last days. Barnie Frank makes $172k a year plus $92k a year retirement been in office since 1972, this is what needs to get changed we need to get rid of the real problems, our politicians. I cant see how these people keep getting re-elected. They want our blue color workers to take "hair cuts" due to their organizations losing money when our federal government organization has been losing WAY more than all them combined over the past 30 years due to how top heavy we are paying out so much in pay and all the perks that they keep adding onto their jobs as civil workers. They should all take a $1 a year paycheck until they get us out of debt and on a more prosperous track for all Americans.

    More taxes is wrong! I should not have to feel locked into any investment except my retirement. And how many retirement funds that are in the stock market lost big time? They where all in very long term... do they get money back from the feds for losing? Will I get tax money for losing if I lose on my investment? I have not invested in stocks until now. I seen this coming back in late 90's way before Bush when houses where getting flipped double the investment. When my wage that I make working my tail off along with my wife wasnt keeping up with rents or mortgages I knew this day was coming. A LOT of americans made A LOT of money during these years so there is a good side i suppose for those that got out but this was caused by OIL rocketing up to record prices, oil companies making record profits 600 billion a year profit I remembers for a few companies, and houses being fliped just for fast profits and loans being made by car salesmen.

    This is STUPID and punishes ALL americans not and not the ones responsible because they will still find a way to rape our lands. Funny how UK banks got 100% of their money back from our funds... seems to me like USA was setup to take the fall!

  • Report this Comment On April 17, 2009, at 11:23 PM, ScottCherf wrote:

    Don't you suspect that if long term investment outperforms short term speculation, short term speculators will be selected out of the gene pool with no further attention?

    Think about it. If you can't think about that, think about anything you like. Just try thinking.

  • Report this Comment On April 18, 2009, at 6:14 AM, PoqSuertMiFav wrote:

    Why not just tax it short term gains at your income tax bracket rate? No need to make the tax so draconian as the 50-100% the Buffett or the author suggests, but if gains on stocks held over a year were the only ones that qualified for the capital gains rates of 15-20%, that would be a more gentle cathartic for this market. If you make the cure too aggressive, you risk making things worse.

    The cure for the trots is not four tincture of opiums, but one. Take the right dose and you won't get stoved up with a seasaw effect that results from an overdose of the right treatment. In medicine as in many things, the dictum,"if some is good, more is better" seldom results in desirable outcomes! The same should apply to our fiscal policies as well.

    Doc.

  • Report this Comment On April 18, 2009, at 7:48 AM, kwill10 wrote:

    "Don't you suspect that if long term investment outperforms short term speculation, short term speculators will be selected out of the gene pool with no further attention?

    Think about it. If you can't think about that, think about anything you like. Just try thinking. "

    Okay, I'm thinking. I'm thinking about my recent layover in the Las Vegas airport and how many people were playing the slots. I'm thinking about how many people play the lottery. I'm thinking the average person who participates in either of these activities is losing money, and yet those who go to Las Vegas and play the lottery have not been "selected out of the gene pool". So, I'm thinking there will always be short term speculators who think they can outperform the market.

    You may or may not like the idea in this article. But to suggest the prevalence of short term speculation means it's superior to investing...I think not.

  • Report this Comment On April 18, 2009, at 9:16 AM, iammainstreet wrote:

    What's this tax supposed to do now, stop the markets from falling? I see China has a stock transaction tax that the communists say is supposed to stop short term speculation yet their market had fallen 70%. There are only a dozen countries left that have not yet abolished the trans tax and their markets have fallen as much as or more than the US. So it looks like the long-term investors are the ones that move the markets to their own demise and look for someone else to blame.

    There is no way to stop long-term investors from selling off. People are afraid of losing 100% of their money. A 90% tax on selling stock would not stop them.

    People have been led to believe that they are supposed to make 10% every year, not every year on average over a lifetime. I really do not think anyone should invest without a course of intensive study and a license certifying them that they understand how the markets work, if they are capable of managing their own finances and the degree of risk they are undertaking. I think there should be levels of certification matching the levels of investment risk. Study hard and ace that test people! I can hear the complaints now, "Ugh, we have to study? We just want to make money right now!"

  • Report this Comment On April 18, 2009, at 3:27 PM, TMFDiogenes wrote:

    Hey Everyone,

    Thanks for your great comments. Like any plan, there are going to be some consequences we can avoid by slight tweaks, others that are unavoidable. I'll try to respond to a few of the issues raised. But before I do so, keep in mind that the criteria on which we should judge this plan is not "is this idea perfect" but "is this idea necessary to change a totally unacceptable situation" and "does the good it will cause outweigh its negative effects." I think this crisis -- which has shown us that a system where executives' and shareholders' interests are unaligned with the health of their own companies has terrible consequences for everyone -- is unacceptable.

    1. One valid concern Tim raised was that this plan would reduce liquidity. That's also a concern Morgan Housel and I discussed when I was writing this piece. To answer this question, I want to bring up something TomG asked a few of us in a meeting one time, which is "what is the purpose of stock markets?" In my opinion, it is to help companies raise capital and to incentivize employees. I think both can be accomplished just as well if NYSE turnover were, say, cut to the 20% - 50% range we saw from 1970 through part of the 1990s. Our economy worked just fine with lower turnover and was probably more stable for it. We still had IPOs and so forth even then. In fact, there could be more IPOs if they didn't have to contend with economic crises like the one we are facing now. Maybe less liquidity would hurt some investment banks' bottom lines, but we should be far more concerned with the efficacy of capitalism and the stability of our economy than with investment banks' profit margins. If banks are going to request bailouts every time the system is on the brink of collapse, it's only fair that we take common-sense measures to avoid putting taxpayers in that position.

    2. A few people asked how this would affect people facing emergencies. That's a valid concern with an easy solution: we can have exemptions to the tax, much like we have for IRAs. And we could afford to be extremely lenient here -- since individuals only account for 20% of stock ownership, it wouldn't limit the effectiveness of the plan to include even borderline requests.

    3. A number of people recommended lowering long term capital gains taxes. That just wouldn't do enough to reduce speculation. It would not cut turnover by a third, which is what we would need just to bring it back to historical norms. We reduced capital gains taxes in 1991 and it wasn't enough to curb speculation -- NYSE turnover rose 2% that very year, and has gone on to triple. We're going to have to attack this problem from both angles to change 150% turnover -- and rising.

    In the last few years, leading up to the worst economic crisis since the Great Depression, investors enjoyed the lowest long term capital gains taxes since 1922-1933. The late 1920s also held the previous record for stock speculation (143% turnover). So other there are other factors we need to take into account, such as the tax spread between short term and long term trades.

    In short, this is an enormous problem. There have been many plans for fixing executive compensation, but very few that attack the root of the problem: the majority of institutional shareholders have every reason to encourage short term gains at the expense of companies' long term interests. It is economically devastating for the interests of a majority of business owners to be contrary to the health of their own businesses. That's the antipathy of capitalism. It also needs to be fixed.

    Like, now.

    Thanks everyone for reading and posting,

    Ilan

  • Report this Comment On April 18, 2009, at 3:42 PM, TMFMmbop wrote:

    Ilan,

    Thanks for the clarifications. You just have to remember that -- though you lead with a Munger quote about the power of incentives -- your're propsing a system that of penalties and DISincentives. And the latter are not nearly as effective as the former.

    Consider, for example, cigarette taxes. Though they raise plenty of revenue for the state, they don't generally dissuade people from smoking (the demand reduction exists, but is minimal from studies I've seen) -- though that's often a reason given for imposing these types of taxes.

    Now imagine instead of taxing smokers, the government paid a healthy behavior benefit to non-smokers of $1,000 per year. Which would cause more people to quit smoking if that truly is the goal of cigarette taxes?

    Just a thought experiment.

    Tim

  • Report this Comment On April 18, 2009, at 4:23 PM, pmzang wrote:

    I think many of us agree that the basic problem is that

    institutional "investors" (not really investors, but speculators) are churning their accounts/portfolios to

    maximize the portfolio returns. Additionally, this in turn

    leads to business managers/CEO's to focus only on the quarter or short term performance. So, why can't

    the government provide DISincentives to institutional

    "investment" managers, WHILE providing INCENTIVES to individual investors of, say, 0% TAX

    on any profits realized from holding a (real) investment

    over 18-24 months. I think combining DISincentives

    with INcentives would address some of this vexing problem a bit more effectively.

    FWIW,

    pz

  • Report this Comment On April 19, 2009, at 8:39 AM, AuburnFool wrote:

    It is absolutely disheartening to see someone propose a tax to modify a behavior. I agree as stated above, taxes should only be levied to fund the essential requirements of government.

    There is a hell of a lot more to this recession than Lehman Brothers. High leverage and low interest rates non-existent savings and shaky business practices across the whole of the economy from individuals to businesses put us where we are at.

    Its time to move on. And taxes are no answer. Shame on you Moscovitz, terrible idea!

  • Report this Comment On April 19, 2009, at 9:44 AM, jdgee2 wrote:

    "It is absolutely disheartening to see someone propose a tax to modify a behavior." [end quote]

    Thank you !

    Jon

  • Report this Comment On April 19, 2009, at 12:27 PM, TMFDiogenes wrote:

    Auburn,

    I agree. High leverage, low interest rates, non-existent savings, and shaky business practices also contributed to this specific crisis. They need to be corrected.

    The plan I suggested (which should by no means be considered immune to revision) is an effort to attack the root cause -- institutions make loads of money by destroying the companies they own. And so long as that's the case, we can bet there'll be destructing speculation on things besides housing and new financial "innovations" to sidestep margin requirements.

    Again -- for people who don't think it's fair to introduce a tax targeting Wall Street speculators -- if 1) you think a capitalist economy can be run by people who don't care about the success or failure of the businesses they own, or 2) you have another way to change the incentive calculus here -- I'm listening.

    Tim,

    Charlie was talking about disincentives too -- the passage actually begins "almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition

    and behavior. But this is not often so."

    But that's a side-note. I really like your thought experiment. As you know, I studied philosophy for awhile, so I think they're oodles of fun. I'm not sure this one applies, though. The average tax per pack is $1.23. That means smoking a pack a day costs $450 in extra taxes. I asked a friend, a former smoker, whether fewer people would smoke if, instead of a cigarette tax, we simply reduced taxes for non-smokers by $450 at the end of the year. She looked at me like I was totally crazy. People smoke because they are addicted to nicotine -- not because it is profitable.

    Another reason it doesn't apply here: I'm not saying disincentives work better than incentives -- which may or may not be true. I'm saying a huuuge disincentive for one activity + reducing smaller disincentives for substitute activities works better than simply reducing the latter disincentive.

    So, returning to the issue: Cutting capital gains taxes for stocks held within a one-year holding period to 10%, 5%, or even 0% without a concurrent speculation tax wouldn't necessarily solve the problem. First, we would have to contend with an unintended consequence of shorter time horizons for long term investors. But more importantly, it's too small to get the job done. A 15% tax on long term capital gains isn't what prevents institutions from being long term investors. Plenty of other industries with lower margins pay 30%+ corporate taxes, and they still have lots of participants. There is too much speculation because it's too lucrative for institutions.

    Limiting stock market speculation by two-thirds -- just to get it in line with historical norms -- would require us to do more than lowering long term capital gains taxes below what are now almost historical lows. We'd also have to make speculation much less lucrative so that capital could be redeployed to investing.

    Again, thanks Auburn, Tim, and everyone for reading and posting,

    Ilan

  • Report this Comment On April 19, 2009, at 3:27 PM, holyshniekee wrote:

    very,very good article. however, i do not agree with imposing higher taxes on short term trading. The government should not be deciding how we invest or trade or speculate. If a trader spots a potentially profitable speculative play, He/she should not be punished by Obama's government for having the market insight and toleance of risk to score a big gain.

  • Report this Comment On April 20, 2009, at 12:15 AM, JibJabs wrote:

    Must every article end with a sales pitch? It drives me nuts and really cheapens the tone of writing to conclude that way.

  • Report this Comment On April 20, 2009, at 3:59 AM, mikejw wrote:

    I don't have a problem with speculation. I just hate the fact that while I as "Joe Investor" can only margin .5 of my account value while some "Super Smart" hedge fund can leverage 30 times what their account value is. I think that contributes a lot towards volatility. If they had to play by the same rules that the average investor had to, it would even the "playing field."

  • Report this Comment On April 20, 2009, at 5:54 AM, SnapDave wrote:

    I plotted the year vs. holding period in the article expecting to find good correlation with computerization of markets and the spread of the internet. Of course there are very limited data points here and I’m too lazy to get my own. What I see instead is a steep linear drop from ’60 to ’80 then a less steep linear drop from ’80 to ’09. At the ’60 to ’80 slope it would have hit zero by 1990 (not likely to happen) so don’t read too much into that. Though that data doesn’t support my internet theory I don’t believe it refutes it either.

    Just thought I’d share this side note as long as we’re throwing ideas around. Maybe it’s not irrelevant to wonder what caused the steep drop at least starting in 1960. Or when did it really start given the data in this article starts at 1960? Surely that’s worth exploring before implementing something as awful as taxing behavior out of existence. Really that will amount to also attempting to tax most shorting and options trade out of existence as well.

  • Report this Comment On April 20, 2009, at 9:01 AM, TopAustrianFool wrote:

    This is nonsense. Taxes?!! That's your solution?!! The solution is for you to start doing your homework and invest in businesses that have the characteristics of long term growth, profit and commitment to long term share holder. And it wouldn't hurt for the government to not bail out anyone. Let them collapse. And I don't want to hear the pantywaist, mollycoddle nonsense of "too big to fail." Grow up and start taking responsibility for yourselves and stop looking for daddy (read government) to provide security.

  • Report this Comment On April 20, 2009, at 9:04 AM, TopAustrianFool wrote:

    One other thing. Without times like these, when would you find bargains? This is a very short sighted article. You can do better than this.

  • Report this Comment On April 20, 2009, at 9:32 AM, outoffocus wrote:

    I've been avoiding this article because of the headline. Then I read it and thought "brilliant". This was a very well thought out article.

  • Report this Comment On April 20, 2009, at 11:43 AM, Deepfryer wrote:

    "But that's a side-note. I really like your thought experiment. As you know, I studied philosophy for awhile, so I think they're oodles of fun. I'm not sure this one applies, though. The average tax per pack is $1.23. That means smoking a pack a day costs $450 in extra taxes. I asked a friend, a former smoker, whether fewer people would smoke if, instead of a cigarette tax, we simply reduced taxes for non-smokers by $450 at the end of the year. She looked at me like I was totally crazy. People smoke because they are addicted to nicotine -- not because it is profitable."

    The only reason she looked at you like you were crazy is because, as you said, she is already addicted to nicotene. But that doesn't mean you had a bad idea - I think your idea would in fact greatly reduce the number of smokers, primarily because a lot more people would never smoke that first cigarette to begin with, and therefore would never get addicted. Think about it: if you had never smoked a cigarette before in your life, would it be worth it to give up $450 just to smoke that first one? I don't think so... and that first cigarette is the one that really matters.

  • Report this Comment On April 20, 2009, at 12:03 PM, none0such wrote:

    I think if you want to change anything - first you should stop the government from subsidizing home loans by way of allowing interest payments be tax deductible -there are far too many homeowners in the US as we all can see now. Also nix that "one time" tax free wavier on home sales - that treats home ownership as an investment - infuriating!

  • Report this Comment On April 20, 2009, at 12:57 PM, yamsi wrote:

    I totally agree with s0jrtorr.

    Maybe I'm missing something, but I'm loving the volatility. With prices swinging like crazy I'm just looking for cheap prices today that will go up tomorrow to reflect the company's true worth. I don't think volatility today is a problem when things settle down tomorrow.

    The point I'm trying to make is that if Mr Market were always rational we'd never have any good deals. The whole point of value investing is to take advantage of Mr Market's irrationalness.

  • Report this Comment On April 20, 2009, at 1:11 PM, slidexperto wrote:

    I am Canadian, we are used to higher taxes, like right now we are being taxed about 13%, used to be 15%. In my opinion, I prefer all countries should be taxed at a flat rate of 10%, not 15% or 8%, at least it is in the middle. For us, 13% tax is still too high. Not too high, not too low, that is why are not affected much by this banking turmoil and meltdown.

  • Report this Comment On April 20, 2009, at 2:05 PM, TMFDiogenes wrote:

    SnapDave,

    The data I'm using came from NYSE Factbook, which begins at 1960. http://www.nyxdata.com/factbook

    We can't be sure why turnover declined from 1968-1970 and from 1972-1974. A few candidates are the economy, short term capital gains taxes, and long term capital gains taxes.

    It probably wasn't the recession in the late 1960s, since that didn't begin until Dec 1969, though the economy remained rocky, so that could easily have been a contributing factor.

    There's a chance that it actually was the major capital gains tax hike that began in 1968 to finance the Vietnam War, and gathered steam through the early 70s:

    "In 1968, the Congress enacted a 10 percent surtax to help finance the Vietnam war. The surtax was in effect between April1,1968, and April 1, 1970, and raised tax liability by 7.5 percent in 1968, 10 per-

    cent in 1969, and 2.5 percent in 1970. It raised the maximum marginal tax rate on capital gains to 26.875 percent in 1968 and 27.5 per-cent in 1969.

    The Tax Reform Act of 1969 included three major provisions affecting long-term capital gains. First, it phased out the alternative tax over a three-year period for taxpayers with gains over $50,000. Removal of the limit on the alternative tax by itself raised the maximum tax rate on capital gains to 35 percent by 1972. Second, the act introduced an

    add-on minimum tax on tax preference income above a specified exemption. The untaxed half of long-term capital gains was counted as a preference in computing the minimum tax. Finally, it introduced

    a new maximum tax of 50 percent on "earned income,"compared with 70 percent on"unearned income," but provided that the benefits of the

    maximum tax be reduced by 50 cents for every dollar of tax preference income. This "poisoning"of the maximum tax also increased the tax

    rate on long-term capital gains for some taxpayers."

    http://74.125.47.132/search?q=cache:-HpCBQHqi2IJ:www.cbo.gov...

  • Report this Comment On April 21, 2009, at 11:24 AM, 449dogs wrote:

    This is by far the best explanation for our current financial crisis. The only thing not mentioned in the article is the relaltionship between the financial health of a company and the jobs it creates. A nation of speculators and broom pushers is not going to keep this country the powerhouse it can be. Long term goals over Wall Street speculation must be a priority, regardless of the mechanism with which we accomplish the goal.

    449dogs

  • Report this Comment On April 22, 2009, at 5:19 AM, SnapDave wrote:

    Looking at the rest of the data from your link certainly changes the picture. As for periods of declining turnover, all coincide with economic and/or market strife excluding the early sixties that I simply don’t really know anything about. As for the real question of why the general uptrend in turnover maybe it has to do with financial/market innovation. This may be one more way that Wall Street has become too smart for its own good and ours.

  • Report this Comment On April 22, 2009, at 12:53 PM, MaxPower13 wrote:

    Ilan, very thought-provoking article. One of the few recently that has led to an interesting conversation, as opposed to 20 people telling the auther he's an idiot. I do agree with your premise that something needs to be done to disincentivize (is that a real word?) short-term trading. However, I agree with several comments that using taxes to drive behavior is the beginning of a very slippery slope. And it's certainly not in line with the ideals of capitalism. This is truly a symptom of a society-wide disease, where it seems like everybody is driven by the need for instant gratification. Until that changes, all fixes will continue to be short-term in nature. I don't know what the right answer is, but somehow we need to return to a society where people are willing to put in the time and effort to build things over years, instead of looking for the immediate buck.

    Let me ask what may be a naive question... can't boards still fight off efforts by short-term stockholders to abandon long-term goals in favor of making the numbers for the next quarter? Or are the people running most companies these days also only concerned with short-term profits, instead of growing the business to endure for decades?

  • Report this Comment On April 22, 2009, at 9:05 PM, Sonogoom wrote:

    I agree that higher short term capitol gains would curb speculation. when I started investing several years ago I believe the capitol gains rate was 28%, add on top of that the transaction cost for a buy/sell order was in the neighborhood of $80. So, if you invested $10,000 in a stock, it popped for 5% gain, would you sell? Probably not, taxes would be $140, transactions would be $160, you would get $200.

    Now with lower capitol gains, and transactions aroung $10 you could sell and pocket more like $400.

    I have heard Sen. Kay Baily Hutchinson on CNBC saying that lower capitol gains 'shore up' the market. http://www.youtube.com/watch?v=yjA-X9ui7y4 I think she is just plain wrong.

  • Report this Comment On April 23, 2009, at 10:33 AM, marmoseti wrote:

    It looks like a lot of commentary on this article is looking at the effects of individual stock owner scenarios, not on the market as a whole. Of course there's never a substitute for doing one's homework on an investment! However, much as tax codes already provide significant incentives and disincentives for and against various business operations, applying that concept to activities that affect the stability of the markets is hardly an inconsistent approach.

    I'd be happy to see long term cap gain rates drop in exchange with a rise for shorter term costs, in general (those are good exceptions noted above; there might be a couple of other cases for individuals). It's neither a new carrot nor a new stick, but finding a better balance for their relative weights!

  • Report this Comment On April 23, 2009, at 10:54 AM, THEMATHISNEAR wrote:

    This article's premise is ridiculous -- taxes will somehow make us collectively better investors. Utter nonsense. If you want to really fix the system, start by fixing the biggest problems. First, make boards more accountable to the shareholders than the current management. Second, make management more accountable to the long-term health of the company they run. No more 'golden parachutes' for driving the company off a cliff. Most of the CEO's incentives should be vested 3 to 5 years in the future. If the stock blows up by then, the CEO gets to take it in the shorts along with the shareholders.

    Oh, and by the way, if you're smart enough to ferret out the impending doom of the next Lehman, you DESERVE to make a killing by shorting them early. That's what FREE ENTERPRISE is all about. (Note: this does not condone illegal shorting and hedge fund manipulation, for which the reward should be an extended stay in federal prison.) I think taxing short-term gains at normal income rates is just fine. Using higher tax rates to punish people who provide liquidity is just another poorly-thought-out idea that, if enacted, will almost certainly end up in the bin marked, "Well, it sounded like a good idea at the time..."

  • Report this Comment On April 24, 2009, at 10:32 AM, lordhep wrote:

    I think the fallout that we have seen happen shows that behaving like a short term investor carries it's own punishment.

    I'm not really in favor of sending more money to this government so they can use it against me. The government is more or a threat to my freedom than any terrorist group, let's not give them more funding.

    There has to be another way to change investing behavior other than taxes,... My idea is to Educate, Amuse and Enrich! Get everyone you know to become a foolish investor. That's the best medicine!

  • Report this Comment On April 24, 2009, at 2:05 PM, no29 wrote:

    Great discussion. I would like to make two points.

    First, I have a problem with the "Too Big to Fail" concept. It seems that about a century ago, it was recognized that monopolies were not the best business model for this country. Hence, anti-trust laws. The idea as I understand it is that there is less likelihood of systemic failure if there are many small players rather than a few big ones. But there has been little serious enforcement of these laws for decades.

    Second, I think that the average holding period of securities has been affected by a generalized desire for instant gratification fueled by technological improvements in the trading system. In itself, the speed in not a bad thing, but it does change gross market behaviors. Just as there are people who smoke or not, and people who gamble or not, some people will have short horizons, and some long.

    I would much rather see market rules that increase the robustness of the system rather than governmental regulation of behavior.

  • Report this Comment On April 24, 2009, at 5:42 PM, eldetorre wrote:

    Quotes and comments:

    "Second, a tax would be unable to differentiate between a speculator and someone who may have just had a family emergency"

    As mentioned: Tax credit for emergencies.

    "markets less efficient since fast institutional money is often what clears up valuation discrepancies."

    Fast institutional money is creating the valuation discrepancies.

    "First make boards more accountable to the shareholders than the current management."

    Did you read the article? The majority of shareholders are short term investors looking for a quick buck.

    "Second, make management more accountable to the long-term health of the company they run."

    What happens when 2 is in conflict with 1?

    "I am not in favor of taxes to control behavior. Taxes should be used solely to fund the necessary functions of government, nothing more."

    Nothing else mentioned will work. People are naturally short sighted animals. The people on this board who are market economy purists simply don't get that the market economy is not at all efficient. It is only expedient. This is because there is always a temporal disconnect between price and realized value. The only way to realize value is to take a longer view.

    Unfortunately education, hope and philosophizing can't do this. The only way to combat short term stupidity is with short term and immediate disincentive combined with long term incentive. This can and should not result in more taxes just differently distributed taxes.

  • Report this Comment On April 24, 2009, at 6:39 PM, PetRock235 wrote:

    My suggestion is to deduct 3% from the capital gain for each year held. Over 33 years - no tax. Since long term inflation is around 3%, this reduces the tax that is only due to inflation. Tax the remainder at ordinary income rates. That will minimize tax shelters that convert income to capital gains.

  • Report this Comment On April 25, 2009, at 12:12 AM, jonas80 wrote:

    Lets not use taxes, instead lets restrict voting rights! Only shareholders who owned their stocks for more than a year get a right to vote.

    Personally I am reluctant to use taxes to reduce speculation. Maybe its because I like some volatility because it gives me a chance to buy great companies at discount prices. Nevertheless, for the greater good of the economy, I agree that company executives should be more focused on long term growth and not short term profits.

    To prevent speculators from voting in short sighted executives, I propose that only shareholders that have held their stocks for over a year get the right to vote. That would give investors(as opposed to speculators) much more power over who gets voted on the board.

  • Report this Comment On April 27, 2009, at 11:26 AM, clairchen wrote:

    This article is wonderful! Germany (where I live and even sometimes invest) has only just introduced capital gains tax this year, at a flat rate of 25% (or your ordinary income tax rate, whichever is lower), whereas previously short-term capital gains were taxed at the standard rate for your income and long-term capital gains were not considered income and were tax-free.

    Now that there is no longer any incentive to hold stocks for a minimum period, and the market is just beginning to recover (I actually have a profit on German stocks I bought in December, even though one of them is a bank), people will be tempted to skim off their profits after a few weeks and run. (A nephew of mine is proud of the 600 Euros he earned doing just that --- selling a stock after two weeks when the price had run up --- but last year he might have had second thoughts about subjecting himself to tax he might have been able to avoid.)

    Warren Buffett sees investment as a socially positive activity contributing to public welfare; speculation certainly is not. My suggestion would be to base capital gains tax on the number of DAYS the stock was held, beginning at 100% on the first day and gradually and continuously reducing to a reasonable level after a year. There are reasons why even an investor might need to sell stock after a brief holding period, but there should certainly be a strong incentive to hold it longer.

  • Report this Comment On April 27, 2009, at 3:30 PM, reggidmalc wrote:

    Another useful tax change would be to allow faster writeoff of capital loss carryovers ...limited now to $3K per year. I will have to make some quick gains in order to use up my carryover. I would suggest raising it to $10 or $20K per year. "Economic Stimulus".

  • Report this Comment On April 28, 2009, at 1:52 PM, iammainstreet wrote:

    Why only stocks? Let's not stop there. A good tax can be applied to every industry with the same results.

    The super tax will prevent another real estate crisis. There are way too many people that would love to have a short-term speculator or even a long-term speculator buy their house right now. This can be discouraged with an increased tax on gains if there are any and a transaction tax even if there are no gains. There is no good reason why these people cannot buy and hold their house other than that they only made a mistake, and did not intend to be a short-term speculator. This is serious. People need to think about the investments they make and all the unforeseen things that will go wrong. There are too many people looking at a house - or stock - as an investment and not thinking about how it might not work out. This tax will teach them a lesson. Not only will their bad investment not gain as much as they had hoped, what gain they had will be severely taxed if they decide to sell.

    This tax will encourage people to not only hold on to a bad real estate investment, but it will also prevent real estate crashes benefiting all of us as a whole. We cannot have every individual make their own decisions that would benefit themselves the most. This tax will benefit not any single one of us, but all of us. This will encourage people to give more thought to the purchase of a house. There had been too much buying and selling of houses. This has got to stop. This is what caused the crash. The housing industry has gotten too big to fail because of the stinking speculators, individuals buying and selling houses when they felt it was necessary. If you buy a house you should keep it. The tax should completely stop short-term trading of houses and real estate, and severely reduce long-term trading for an added benefit. We need a super tax on house speculating to shrink the industry down to a size small enough to drown in a bathtub. It's just wrong to have someone take over the risk on a questionable investment that someone does not want and wait a few months or a couple years to possibly make a profit to compensate for that risk.

    Let's have a substantial tax on US and only US made autos because the manufacturers are obviously focused only on the short term wants of the auto consumer and therefore only on short term earnings and not the long term future of the company. Let's shrink US auto sales and turnover down to 20% of what it is now. This will stop all those huge auto maker crashes. The auto industry has gotten too big to fail. This is what causes bailouts like the first Chrysler bailout of 1979 and now they want more bailouts. This has got to stop. The tax will control the natural, cyclical ups and downs and prevent the intolerable crashes.

    It's not the auto makers' fault. They are being driven by the individual consumer. The individual must be stopped. Auto consumers are like stock speculators looking for a better deal, something new, and instant gratification. They cannot wait to buy a new car. The super tax will put a stop to that. Why can they not buy and hold the same old car? The short term wants of the consumer drives the auto makers to wastefully spend what could be billions of dollars of profits to develop new models every year trying to please the consumer, and the shareholders are demanding the same. People will complain that they need a new car. That is like a stock speculator saying that they need a new stock, even if they did not intend on being a speculator.

    The huge, out of control companies really should not be made responsible for anything. It's the individual's behavior that must be controlled. The flock of sheep must be culled further as some are thinking for themselves and are attempting to make their own choices. The good news is that the individual is already weak, defenseless and running out of choices and options. Let us reduce the choices down to buying a US made car with a hefty tax or a foreign car with little or no tax (investing in heavily taxed US stocks or investing in much lower taxed stocks overseas). That will get the US economy going!

    This is a most logical tax, for a logical tax can be applied to every industry for the benefit of all. I have consulted my colleagues, and they agree with me, the super tax is the answer to our problems. This is my idea. Mine. I encourage responses, but I'm not listening.

  • Report this Comment On May 03, 2009, at 3:18 PM, STOCKS2076 wrote:

    I think it's a ridiculous idea.

    First of all - I am an investor as you descibe. This is because I don't have the time, nor the insight to trade stocks rapidly on a daily basis.

    That said - why is it that "Investors" are better than "speculators" and as such, investors deserve to keep their gains, and speculators should forfeight 60% of theirs to the government? Why is the speculator to be penalized? Making money fast is "bad" and making money "slow" is good? I'm sure none of you "holyier than thou" investors wouldn't utilize a genie to tell you tomorrows stock price if you could. No, no, no, -you would ask the genie for NEXT YEAR's price wouldn't you?!

    Don't be ridiculous. We all want to make as much money as we possbily can as quickly as we can. We choose to be investors for many reasons - most similiar to my own. But don't demonize people who jump in and out on a daily basis all because they have the time and courage to do so.

    finally - I don't agree with the notion that the CEO's don't have the long term viability of the company at heart. While I agree that too much emphasis is placed upon making the quarterly numbers, the CEO will be there for years, and HE/She knows it.

  • Report this Comment On May 14, 2009, at 6:04 PM, TerranFirebat wrote:

    Anyone arguing for higher taxes is insane or a socialist or both. Govt needs to cut wasteful spending not collect more pork funds in the interest of promoting the common good. Last thing we need are more senators joyriding on private jets for a junket to the caribbean to study global warming.

  • Report this Comment On May 18, 2009, at 6:43 PM, NotCrazy wrote:

    I'd be against such a tax for two basic reasons.

    The first is, it's against the Constitution. What you're proposing is not a tax meant to fund government, but a penalty for legal behavior. That is, I think, forbidden by the due process clause. If you think it's not, please explain to me how this would be different from a tax meant to punish reading fantasy novels or dying your hair green. However much you may disapprove of an action, if that action is legal then the government has no Constitutional power to punish it. If it is illegal, then punishment must be after a jury trial, not by fiat.

    The second is that even if it weren't against the Constitution, the liberty risk here is very great. Everything I said in the above paragraph remains true. Do we really want the self-interested small-souled people that mainly make up the ranks of our elected government deciding what we may and may not do without even needing to pass laws outlawing the forbidden actions?

  • Report this Comment On May 22, 2009, at 11:45 AM, catoismymotor wrote:

    The power to tax is the power to destroy. An unnecessary tax is akin to legalized theft.

  • Report this Comment On May 09, 2012, at 11:13 AM, EricTheRon13 wrote:

    You don't need overbearing taxes to limit the micro-second trades. A simple 10% excise tax on any trade that's held less than one day will do it. You would have to have some sort of exclusive licensing for brokers, exchanges, and market-markers, of course, but licensing could be limited. No security needs more than 3 market-makers. Most of these are licensed anyway, it's just not limited currently.

    However, your assertion that anyone who doesn't subscribe to "permanent buy and hold" is just speculating is specious. Anyone can buy a good company and later determine that the company is not turning out as you expected, causing a sell. Berkshire does this too. Also, there is no black mark for recognizing the enduring truth of "for everything there is a season". This is wisdom, not heresy.

  • Report this Comment On October 29, 2012, at 7:08 PM, theno1patrick wrote:

    Old article, but I just read it and I 100% disagree. 2 major reasons: First, liquidity. how would you feel if everyone was a multiyear b&h investor, would you be comfortable paying 10, 20 or even 30$ spread on a purchase, what about paying the same when you exit? or perhaps the broker-dealers will have less incentive to keep commissions low, if you have people holding stocks for 2-3 years at a time theres no need to innovate trading platforms, no need to compete on commissions, they'll have no reason not to increase them back to 20-30$/ trade like they were in the late 80s-early 2000s.

    Secondly, If you are not at a senior director or executive level company insider, by definiton you are speculating. You are speculating that company management has your interests in mind, you are speculating they'll grow faster than inflation and the economy, you're speculating if you're not a controlling owner.

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