Capital Gains & Incentives

Every few years someone proposes raising the capital gains tax. Here's brief thoughts on why that's a terrible idea.

When governments don’t have enough money to pay for things there are four levers to pull:

  1. Raise Taxes
  2. Cut Spending
  3. Print Money
  4. Lower Interest Rates

Over the past 20 years, we have printed money and lowered interest rates. Since 2008 the Federal Reserve Balance Sheet has grown from $1T to nearly $8T dollars. That’s Trillion. With a T. It’s hard to even wrap your head around that number. Just see the graph below.

And then last year, we dropped interest rates to 0%. This allowed people to continue to borrow money at low rates. Low rates encourage people to borrow money and invest with the hope of creating profits that can pay off that debt. In short, debt helps drive growth. Until it doesn’t. Then you are in a bad spot.

Printing money is easy when you are the reserve currency of the world, which is why we have been doing it. It can be unpopular because you are effectively reducing the purchasing power, however it doesn’t have a direct effect on individuals. It indirectly affects you through higher priced goods so you may not directly blame the politicians who encouraged the money printing. Lowering interest rates is popular because who wouldn’t like to borrow money at a low interest rate?

And so after we pull those levers as much as we can, we’re left with two options: raising taxes and cutting spending. These are the most unpopular. It hits you directly. You see it in your paycheck. Or the programs that you benefit from. Politicians obviously don’t like doing these because how will you get re-elected by taking away money from people? And that brings us to this week’s news of Biden’s alleged proposal to raise the Capital gains tax rate from a top rate of 23.8% to 39.6%.

The first-order effects are obvious. I sell an investment and I get taxed double versus what I previously expected.

More importantly, there are second and third-order effects. By increasing the capital gains tax rate I believe we fall into a vicious cycle of not being able to allocate productive capital, because the government decides they should allocate it. Let’s use an example:

  • Jenny sells an investment after a handful of years with a $1M gain
  • Jenny wants to re-invest her entire gains, but first needs to pay taxes of $390,600 (increase from $200,000 from the current tax rates)
  • So, Jenny’s re-investment amount is now $600,400 versus a previous re-investment that would’ve been $800,000
  • Jenny can either invest a lower amount into 1 company, or provide capital to multiple companies, but not as many as she would’ve funded previously

You can see how this cycle works. The additional capital that would’ve been invested into companies is now being transferred to the government to allocate. If there’s one entity I don’t trust with capital allocation it’s a bureaucratic institution with perverse incentives and limited accountability. But where does government actually spend this money?

Biden’s proposed budget for next year in $1.5 Trillion. How do we measure the return that we get on these expenses? How much excess spending, or waste, is in this budget? If going to the DMV is any indication, we know there’s A LOT of waste. We currently have 10M people employed by the federal government and a large part of the economy is supported by federal government spending (defense & military, construction, healthcare, etc). The graph below doesn’t show the recent administrations, however look at how this budget continues to grow (along with a growing deficit).

Does anyone ever stand up and say, “Hey, maybe we shouldn’t spend so much money?” My immediate (and potentially naive) line of thinking is we need to first re-define the role of government. Is their role to protect us? Is it to provide us with healthcare? Is it to not let anyone get left behind? Let’s first define our priorities. Then let’s start with a zero-based budget where we define how we allocate capital and how we measure return. From there, we can then determine what revenues need to be generated vs. a proposed budget, how much of a deficit (or surplus) we are comfortable with, and then a recurring review of how these programs are performing where we eliminate programs that don’t work and double down on ones that have an impact.

In these times, when we have a debt-fueled economy, low interest rates, and a money printer on steroids, we’re all going to need to feel some pain with structural changes. We’re in the late stages of a long-term debt cycle and there will need to be some de-leveraging. But let’s be deliberate about the changes we make and understand the entire short-term and long-term ramifications of these changes. Myopic thinking and class warfare is not going to fix the problems we face today.