Investment Climate: The Nonsensical Capital Gains Tax
Investors in Taylor Frigon Capital Management’s growth investment strategies enjoyed the best quarterly performance they have had in the last few years. All portfolios ended the quarter with YTD performance that was well in excess of the general market, and the performance was broad-based, across a number of industries and sectors. In our last quarterly commentary, we outlined a major change that is brewing in computer architecture for which we are positioning our portfolios. Some of those themes have already started to produce. And even some of our “older theme” positions have taken off, as well. It is particularly notable that we believe we are seeing the beginning and by no means the end of certain trends. Thus, there is no one aspect of our portfolio management process to which we can attribute the performance. We also noted last quarter that we transitioned out of a number of very long-term holdings that resulted in significant realized gains. This transition has evolved over the last couple of years and we are pleased that we are much closer to completing that process than beginning it. Needless to say, this results in the realization of long term capital gains and, therefore, the payment of capital gains taxes. We will do everything we can to mitigate the impact of capital gains in our strategies, and considering we generally hold positions in our portfolio for many years exemplifies that approach, in contrast to management styles with higher turnover. However, there comes a time when we have to realize our gains and reposition our capital in places we think can provide better returns in the future.
This necessity provides an excellent opportunity to reflect on tax policy and its impact on business and investment.
Anybody who is facing the hard, cold facts of paying taxes on capital gains understands how annoying, and even painful they can be. In high-tax states like California and New York it is simply excruciating! This allows those payers to understand that taxation affects behavior. It often affects actions so much that people will make very bad investment decisions just to avoid taxation. One example happens when investors blindly look to realize losses in companies that may be very solid long-term investments just so they can offset capital gains. In other words, incentives matter, and tax incentives can lead to self-damaging decisions.
We struggle with the fact that tax law is inept, demonstrated by the fact that long term investors in real estate are given a favorable way to avoid capital gains taxes (1031 tax free exchanges, or “Starker Exchanges”) for “exchanging” (another word for “trading”) from one “like-kind” property to another, if done using a proper intermediary. However, if one were to “exchange” (or trade) shares of Home Depot common stock for the shares of Lowes common stock (a like-kind exchange if there ever was one!) and did so by selling the Home Depot shares at a higher price than they had originally paid for them, he or she would have to pay a capital gains tax on the profit. This creates a disincentive to making the trade, and a disincentive to investing in stocks altogether. It favors investment in real estate over investment in the equity of a corporation. It also incentivizes the real estate investor to over-pay for property just to avoid the tax (under 1031 exchange rules, the investor must identify a new property within 180 days) thereby driving the prices of properties higher than they would have been if the playing field were level.
None of this activity is grounded in sound economics. It ultimately results in distortions and misallocation of capital, all of which hurts the economy, and ultimately costs us all in the form of lost jobs and even failed business. With all the talk about taxes in the last year (and we would add that we believe there were some very positive aspects of the new tax law), we would’ve hoped the “un-economic” aspects of taxation would be addressed. But they were not. In many cases, taxes just got more complex, or at least were not made any simpler.
When we address this topic, we are often asked about a solution. We have long stressed the solution is in true simplicity and a broadening of the tax base. Here, we would argue for the lowest, flattest tax rate applied across all forms of income such that the incentives are all equally aligned to foster economic activity, favoring no one group or industry, and giving everyone a stake in the system.
Does that sound simple enough?
Do we think it will happen?
Because politicians make the rules.
Meanwhile, we will continue seeking out companies that make it possible to, as Dick Taylor would say, “get by in spite, ” and preferably “THRIVE” in spite!