The GameStop Debacle

The GameStop debacle is a the most recent manifestation of our history of allowing tax law to favor speculation over production. It is about clever gamesmanship by individual speculators exploiting the predictability of Hedge fund speculation. The damage to our economy has so far been limited to disruption in the financial markets, but when it first happened that was also true with the Great Recession. We don’t know how this will play out as the billions of dollars changing hands ripple through the economy.

The line between when investment becomes speculation is fuzzy. But it is pretty clear tax policy in the United States has favored speculation over investment since Ronald Reagan began cutting taxes on the wealthy in the 1980’s. What is going on right now in the financial markets is directly related to our tax law does not recognize that speculation is not necessarily useful investment.

The history of the last 100 years documents that periods of excessive speculation regularly follow Republican control of tax policy and end up badly. Republicans have consistently enacted policies that reward speculation. Policies that, perhaps inadvertently, make it easier to make money speculating than in actually producing goods and services. Consider the following historical facts:

Republicans took control of Congress and tax policy after World War I. In 1923 they lowered income tax rates on the wealthy and created the Capital Gains tax (before 1923 Capital Gains were treated like all other income). Once folks realized the impact of the tax law changes a stock investing fever swept the country resulting in the Stock market crash of 1929 that tipped the country, and much of the world, into the Great Depression.

In 1933 the Democrats gained control of the levers of government. The tax policies the enacted, higher tax rates on the wealthy and higher rates and more restrictive rules on the application of the Capital gains tax, were maintained over the next 47 years. The last 30 of those years were the most productive and stable period in US economic history. There were no depressions or major recessions, we experienced strong growth and we paid down most of the National debt incurred in the Great Depression and World War II. Buying power of ordinary working folks expanded to the highest point in our history.

In 1980 Ronald Reagan’s election swung policy control back to Republicans whose foremost policy goal was to cut taxes. Making the Capital Gains tax rate more attractive to speculators was a big part of their game plan.

It is not a coincidence that in the nearly nearly four decades since Reagan to office:

1. The National debt that had been reduced each year from after World War II through 1980 reversed course and has risen every year since.

2. The purchasing power of working folks stagnated and is lower now than it was when Reagan took office.

It is also not a coincidence that in 1987, a few years after Reagans tax cuts made the Capital Gains rate much lower, we had the first major stock market crash since the Great Depression.

Democrats still controlled the House up through 1994 so were able to somewhat moderate the Republican tax changes. But in 1995–96 Republicans took control of both houses of Congress and held control for the next 12 years. They immediately cut income tax rates, particularly on the wealthiest taxpayers, and made huge changes in the Capital gains tax law that tipped the balance further away from favoring investment and more toward favoring speculation.

Those 1995–96 tax changes created the modern Hedge-Fund industry, a industry built largely on exploiting gaps in our tax law to make lots of money, with little regard to production or employee welfare, by avoiding taxes and warping the stock markets with their gamesmanship.

The 1995–96 Capital Gains tax law changes also created the conditions that produced the speculative housing market bubble that burst in 2007 and led us into the Great Recession, the biggest economic downturn since the Great Depression.

GameStop is one more wake up call that Congress needs to tip the balance away from favoring speculation and back towards favoring production. The formula that worked in the middle part of the last century was high marginal tax rate and higher and more restrictive Capital Gains taxes.

But the tax law wasn’t perfect back then, there was lots of room for improvement. One big improvement would be to get rid of the Capitals Gains tax altogether. It is a needlessly complex solution to a simple problem. It’s complexity will always create opportunities for clever speculation.

The Capital Gains tax was created in the early 1920’s in the aftermath of a horrendous bout of inflation after World War I. In the early 1920"s people who sold a business, or a property, or some stock, found that they owed taxes even though the asset they sold hadn’t really increased in value, or perhaps even lost value, after you factored in inflation. But on paper since they sold the asset for a higher price than what they bought it for, the tax folks regarded that as a taxable gain. That created a drag on investment — who wants to buy or sell something if you might end up being taxed when you sell even though you might actually be taking a loss because of inflation.

The logical solution would have been to just add an inflation factor to separate the effects of inflation from how much you actually gained. But instead of applying an inflation adjustment, Congress set up an simplistic scheme whereby the gain would be taxed at lower tax rates than what would ordinarily apply. The scheme greatly benefited the very rich in high tax brackets, and made speculation in assets very attractive. Not a coincidence that six years later the 1929 Stock Market crash brought our economy to its knees.

Requiring tax payers to adjust for inflation does sound daunting. It would either require people to do complex arithmetic calculations, or government would have to provide inflation charts that were updated regularly. The government option was an anathema to the Republican Congress of 1923 that was first and foremost dedicated to minimizing government. But today government agencies already constantly monitor inflation, and software programs could make computing actual gain a simple formula available online. Plug in your date of purchase and what you paid, then plug in the sales price and the date of sale and it computes your taxable gain.

We should maintain the rule that allow Capital loss to offset Capital gain — a rule that reduces friction in investing. But otherwise Capital gain should be taxed as ordinary income after adjusting for inflation. Having Hedge funds and day traders buy and trade stocks on constantly trading to squeeze out profits that will be lightly taxed discourages long term investment and pulls a lot of smart people out of trying to produce a good or service and into making a fast buck from clever stock deals.

In the constant partisan war that characterizes politics long term solutions are easily pushed onto the back burner. But thirty five years of rising National Debt and rising income inequality need to be addressed. The long term solution is wiser tax policy which would also be a wiser political strategy for the party in power that wants to build a strong economy. Republicans enjoy an unwarranted reputation for being good at building economies. Democrats need to make the economy and issue if they want to stick around long enough to accomplish much.