Hillary Clinton's proposal to extend the holding period for preferential tax treatment on long-term gains is not novel, but to the extent that its intention is to discourage short-term trading, it could backfire.

Advisors will find there may not be enough of an incentive for clients to hold onto their securities for longer periods. In fact, it's likely to have the exact opposite effect, as it sharply reduces the benefits of holding long-term, while extending the time that a security must be held in order to qualify for preferred treatment.

While there's no data supporting how changes to the capital gains tax have affected short-term trading, a close look shows how the savings plays out and advisors can decide for themselves how they believe their clients will react. Academics already believe such proposals could lead to the opposite of what they intend.

"At its core, the decision is a matter of choosing between a short-term investment strategy and a long-term one, a decision that also must factor in the tax rate of capital gains or losses and the investment time period. In other words, what is the break-even point between these two strategies?" Montclair University professors James G.S. Yang and Seddik Meziani write in The Journal of Investing.

Before diving into Clinton's proposal, it first helps to know that capital gains haven’t always been taxed at a lower rate than ordinary income, or that 12 months hasn’t always been the minimum time required to hold a stock to receive the most beneficial tax treatment.

A Varied Landscape

From a tax standpoint, dividends and long-term gains are currently given preferential treatment over salaried income, but that wasn’t always true. In the early 1970s, for example, salary was taxed at a maximum of 50%, while investment income could be taxed as high as 70%. In other words, earned income was treated more favorably than investment income, the opposite of today.

When the first personal income tax came into law in 1861, capital gains were not included in the definition of taxable income and thus were tax exempt. That changed by 1864 when they were included in the definition of income for the first time.

Initially, capital gains were taxed at the same rate as ordinary income, and it wasn’t until 1921 that long-term gains first received preferential treatment and began being taxed at a lower rate than ordinary income.

Yet this change was far from permanent: As recently as 1986 to 1991, capital gains were again taxed the same as ordinary income.

Minimum Holding Periods

Under Clinton’s proposal, a new system of multiple holding periods and corresponding tax rates would be introduced for long-term gains.

Short-term gains would still be taxed at the same rate as ordinary income, and the definition of the short-term holding period would be extended from one to two years.

Profitable trades on securities held more than two years would be considered long-term gains and taxed at 36%, a modest break from the 39.6% ordinary income tax rate that would otherwise apply. (Her proposal apparently applies only to that portion of a taxpayer’s income that falls into the 39.6% tax bracket.)

A sliding scale of declining rates would apply to gains on securities held three-to-four years, four-to-five years and five-to-six years. The current 20% long-term capital gains rate would apply only to securities held for more than six years.

A Sliding Scale

The concept of a sliding scale for taxing gains is also not new. In 1934, there were five different capital gains tax rates for different holding periods.

In 1938, the number was reduced to three graduated tax rates and a holding time of less than 18 months was considered short term, while a super-long-term holding period of five years was taxed at half the rate of ordinary income.

By 1942, Congress further simplified the rules to include just short-term or long-term holdings, with long-term defined as anything held more than six months (down from 18 months).

The minimum holding period to qualify for the preferential rate was lengthened to nine months in 1977 and finally to 12 months in 1978.

In 1997, when he was president, Bill Clinton signed a law that contained a lower tax on super-long-term holdings. But that rule was repealed (because it caused too much complexity) in 1998, before anyone could take advantage of the lower rate.

Unintended Consequences

Now for an example of how the Hillary Clinton proposal may end up having the opposite effect of what it sets out to do: A client buys a stock at $50. Eleven months later, the stock is at $60, up an impressive 20%, and the investor would like to sell.

Under today’s law, the choice is to hold for one more month and keep $58 or to sell immediately and keep $56.

But under the Clinton proposal, if your client wanted to take a long-term gain, you would have to tie up your money for 13 months more, not one month, and, even then, you would keep only $56.40.

Reduced Incentive

This may tilt clients toward selling earlier and not holding on to get a tax break that is actually smaller than what is currently available. Now, the difference in tax between a short-term investment and a long-term holding is about 50%. Under Clinton’s plan, there is only a 10% saving if an investor holds an asset for the minimum two years.

Today, a client can cut his or her tax almost in half (from 39.6% to 20%) by holding onto a profitable position for just over one year. But, if Clinton’s proposal becomes law, it will take six years instead of one to accomplish the same.

For shorter periods, the incentive to wait before realizing gains is substantially reduced. Taken together, these changes are less likely to encourage clients to buy and hold, and may lead to more short-term trading, not to less.

Robert Gordon is a contributing writer for On Wall Street, adjunct professor at New York University Stern School of Business and president of Twenty-First Securities.

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