Clinton and Long-, Medium-, and Short-Term Capital Gains

clinton logoHalfway through an extensive post on Hillary Clinton’s new tax proposal, announced Friday, I managed to lose the whole thing. Which is fine, I guess, because, while giving a lot of details about her proposal, and about capital gains in general, I wasn’t writing what I find really interesting about it: the fact that it is neither radical nor conceptually new.

In brief: currently, there are two holding periods applicable to capital assets[fn1]. If you sell your capital asset one year or less after you bought it, you have a short-term capital gain; if you sell it more than one year after you bought it, you have a long-term capital gain. You pay taxes on short-term capital gains at your ordinary tax rate, while you pay taxes on long-term capital gains at a lower rate (0%, 15%, or 20%, depending on your tax bracket).

Clinton proposes to increase the number of holding periods to six (though only for taxpayers in the highest tax bracket). Tax rates on capital gains would be on a sliding scale, decreasing as high-income investors’ holding period increases:

Holding periods

Creating six different capital gain holding periods seems radical, frankly, in part because there have only been two during my whole career (and, in fact, for most of the history of the federal income tax). But there haven’t always been just two; this CRS report gives the details, but I’ll summarize:

From 1913 until 1921, capital gains were taxed at the same rate as ordinary income; thus, holding periods were irrelevant.

In 1921, Congress introduced the idea of a preferential rate on capital gains and, in doing so, also introduced the idea of long-term and short-term capital gains. Gains on capital assets held for two years or less were taxed at ordinary rates, while taxpayers could choose to pay a flat 12.5% rate on gains on assets held for longer than two years.

Then, between 1934 and 1938, we got what strikes me as the precursor to Clinton’s proposal. Rather than long-term or short-term gains, the tax law provided five holding periods: (a) one year or less; (b) more than one year but not more than two years; (c) more than two years but not more than five years; (d) more than five years not more than ten years; and (e) ten years or more.[fn2]

Rather than a preferential rate, the various holding periods corresponded with the amount of a taxpayer’s capital gains she had to include in her gross income. If her holding period was (a), she had to include the full amount. If it was (b), she only had to include 80%, (c) and she included 60%, (d) and she included 40%, and if she held it for more than ten years, she only had to include 30% in her gross income.

In 1938, the tax law left the sliding-scale holding periods, and went back to long-term and short-term. The length of time that marks long-term has since varied between 6 months and 18 months, but we haven’t gone back to a sliding scale.[fn3]

So Clinton isn’t proposing that we go to uncharted territory; rather, she’s looking to revive an experiment that has already happened. How did it go last time? I don’t actually know—I never thought to look until Clinton made the proposal on Friday. But should her proposal be implemented, there’s certainly value in knowing how it went before, so that we can retain the good parts and avoid the bad.

[fn1] For our purposes, let’s say that “capital assets” are basically investment assets, like corporate stock.

[fn2] The CRS report gets the holding periods subtly wrong; the right ones are available in section 117 of the Revenue Act of 1934.

[fn3] Between 1986 and 1990, long-term and short-term capital gains were taxed at the same rate, but technically, the 1986 Act doesn’t appear to have eliminated the binary.

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