October 9, 2008

The Next Step: Suspend The Capital Gains Tax, and The Market

Extraordinary times call for extraordinary measures.  Move.

What is happening now is not related to fundamentals.  Major companies are being discounted much more than their already lowered future earnings estimates would predict.  Stocks are being priced not for recession, but for Depression.

Ten years of growth have been eliminated, and for what?  Does anyone even know why they are selling? 

It isn't a matter of earnings or even recession; at this level it is all about a lack of confidence.  Either stocks have been overly discounted-- yet still there are no buyers, because they lack any confidence in the markets; or they are being discounted appropriately for a coming Great Depression, in which case something more needs to be done to prevent one.

A single sentence on the positives is sufficient: suspending the tax would go a long way to enticing investors back into the waters, whether to ward off Depression or restore confidence.

To those who would express horror at such a regressive notion, consider the following:

1.  Suspending the capital gains tax will have a small relative effect to the budget deficit, in comparison to the bailout(s), etc-- less than $80B. 

In the years 2003-2005, capital gains revenue was $50B, $60B, and $75B, respectively.  Even if the capital gains tax was reduced to zero for one year, the government would stand to lose no more than $80B in mythical money.  I say mythical because, in 2008, what capital gains does it expect to tax?  Even the short selling was banned.  

According to the CBO, in 2002, real estate accounted for 10% of capital gains tax revenue, and stocks 90%. This was during a period of real estate growth and a precipitous stock market fall.  The exact reverse situation exists now.

2.  Capital gains tax cuts lead to increases in capital gains revenues, not decreases.

Prior to the tax cuts of 2003, the CBO projected capital gains for the years 2003-2005 to be $45B, $44B, and $49B-- as compared to the actual revenues of $50, $600B, and $75B.   In other words, the tax cuts increased revenue by $45B over the three years; they had managed to generate an extra year's worth of capital gains revenues. 

One might argue that this lead to asset price inflation which in turn resulted in this collapse; let us grant that this is the case.  The tax elimination is only temporary; can be limited only to  gains starting after, say, July 1; and one can even raise the tax later.  This reduces the lost revenue from $80B to any number desired.

The point is not whether tax cuts do or do not lead to asset bubbles; the point is explicitly to prop up asset prices, so that real investors feel confident to being buying again.

3.  2008 may be the year where one is taxed on losses.

The S&P500 went from 1229 (Jan 1999) to 1469 (Jan 2000), and then back down to 1320 (Jan 2001).   It may look like a round trip.  But consider that if the 1999's 15% gains were taxed at the short term rate-- to be paid by April 15, 2000-- yet the market was, in that time, falling, one could find himself in the unfortunate scenario of having to pay taxes on gains he no longer had-- in essence, he was being charged a tax just for trying.  With that in mind, observe that the 2000 revenues were the highest of all-- $121B.  Where did investors who had lost the profits get the money to pay the taxes?  They sold the stocks themselves-- contributing further to the already in progress market decline 2001-2003.

4.  The suspension can be phased in according to sector.

Clearly, the financials and financially sensitive stocks (e.g. GE) are the root of the problem.  One can suspend capital gains taxes on these stocks; as they stabilize, so too will the collateral damage which is-- everything.

Alternatively, the suspension of taxes on dividends can be used to bring investors back into those stocks.  Unfortunately, this is the opposite of the current proposal, which is at this time entirely untenable.

5.  Suspension of the tax will lead to increased private foreign investment.

In 1994, foreign investment in the U.S. was $50B.  This rose to steadily to $3.2T (trillion) in 2000-- and then fell back to $50B by 2002.

After the tax cuts of 2003, it rose back to $1.6T by 2006.

If buyers are needed to turn the markets around, bringin outside investment is an obvious solution.

The Time Is Now

All of these manuevers will take time to implement, and even more time for people to digest and respond to them.  Right now, the markets are in a state of free fall with no buyers willing to step in.  This is not a market, it is a the dumping of perfectly good bagels into a dumpster because no one wants them.  The average 401(k) investor is so perplexed by the happenings that it does not seem real to him-- indeed, it is not real, except for the number at the bottom of the statement.  The markets need to be closed, giving investors-- especially large institutions, hedge funds, and rich guys-- time to meet and discuss their terms.