Patient Capital Jude Wanniski July 29, 1997

Memo To: Chairman Bill Archer, House Ways & Means
From: Jude Wanniski
Re: Patient Capital

On the assumption that the tax legislation you negotiated with the Senate and White House will be easily passed this week and signed into law at a festive, bipartisan ceremony sometime soon, I suggest there is no time like the present to begin thinking about next year’s tax legislation -- although I do acknowledge you deserve to do your early thinking on a sunny beach or cool mountain retreat, whichever you prefer. My suggestion is that you think of the concept of “patient capital.” I say this having been somewhat surprised this morning to read that you have once again agreed to a one-year holding period before an asset is eligible for the capital gains differential, of 20% instead of the 39% tax on ordinary income. I’m happy to have learned that you resisted the administration’s attempt to require an 18-month holding period, but believe that one year is too long. Six months at least permits you to buy and sell an asset within a taxable calendar year and makes it unnecessary for investors to pay the hedging costs of locking in gains. No holding period is best of all. The five-year holding period for the 18% rate, which you negotiated in exchange for giving up on indexation, is clearly meant to help farmers and small businessmen, but there is no reason for a minimum holding period in those assets either. My guess is that the way the special 18% rate is written it will prove useless anyway, since it does not address the inflated gains of the past 30 years. In a non-inflationary environment, a five-year holding period @ 18% would hold no interest to investment capital compared to one year @ 20%.

The philosophy behind a “holding period” is that somehow patient capital is better than speculative capital. Why? Because it sounds nicer, that’s all. It suggests less volatility. It is a holdover from the Crash of 1929, when it occurred to some “wise men” that maybe the market would not have crashed if people who were holding capital gains would not have been so quick to sell. The actual holding period requirement has the unintended consequence of making the market less fluid than it would otherwise be, and thus less effective in creating fresh capital.  You may tend to think of it as a way of keeping people inside the market longer than they would otherwise stay. You should rather think of it as a way of keeping people out of the market who might otherwise come in. The holding period reduces the value of the tax differential and thereby has the same negative supply-side effect as a tax itself.

The worst part of a longer holding period is that it discourages capital from flowing more easily into infant enterprises, which may not survive past the holding period. Since most new businesses fail within the first five years of life, a 5-year holding period before getting an extra two points on the tax differential will do almost nothing to bring capital to that asset. It isn’t a bad thing to do, but it does not do what you think it might. It is like a racetrack, where you are allowed to make bets on any of the horses, the favorites or the longshots, but if the longshots win, you have to stay in the racetrack for five years before you can leave with your winnings.

The fact is that the capital market is comprised of tens of millions of people, some who are patient and some who are not, and they are all mixed up together in a pool that is very deep. The reason the market is as efficient as it is, is precisely because people not only have freedom to buy and sell, but that they know there are myriad buyers and sellers. Whenever you begin imposing limits on when or how buying and selling can occur, you make that market less efficient, which means it can support fewer capital transactions. I’m not simply talking about Wall Street. I mean the big, broad market that encompasses all economic activity. It is nice that you squeezed out of the Democrats and the President a lower capital gains rate, because that will engender more productive economic activity and a higher standard of living for all Americans. It is just that with the longer holding periods, it won’t be as good as it might. In next year’s legislation, and in the broad tax reform you are planning, I hope you can take this into account.