Passing financial reform is no miracle

April 22, 2010

Jonathan Chait over at TNR is strangely amazed that financial reform may happen:

What’s happening with financial reform right now is unlike anything that’s happened since I’ve been following American politics. Look at the fundamentals of the issue. This is a matter where a massive industry — one that accounts for close to half of all corporate profits — is adamantly opposed to new regulation. The merits of the issue are so mind-numbingly complex that even economists and policy wonks sound distinctly fuzzy on the details. Throw in a Republican Party that had pursued, with evident political success, a policy of total obstruction. I’d tell you this was a formula either for defeat or a toothless reform.

And yet a substantial reform now appears close to inevitable. It’s not a toothless reform — a set of derivative regulations more hawkish than anybody could have dreamed possible a couple weeks ago just passed through the Agriculture Committee. It’s one of those strange moments when the normal laws of politics have been suspended.

Me:  I am more amazed that given the magnitude of the financial crisis and the level of public rage, the banks weren’t broken up and turned into quasi-public utilities. But Wall Street can thank the White House for that. After passing the stimulus, it decided to focus on healthcare. Time passed, passions ebbed, and the lobbying effort cranked up. But the aftermath of the crisis (+Goldman) always made it likely that reform would pass.


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The banks and investment houses will always reap huge profits either at the expense of clients and/or shareholders as long as it is so profitable to do versus the risk. How do you change that equation, without one single extra regulaiton or regulator? Change the tax code on short term capital gains, derivatives income and gains, and futures trading PLUS establish uniform margin requirements on all trading that requires 80% collateral behind any trade.

Those 2 elements are what changed in the US markets since the 1980s and those 2 specific facts: low taxes on trading (certain option income is actually now taxes at only 10%!) and laxed margin lending requirements (FX Carry Trade by hedge funds lever 1 to 100 now) led to the collapse of the financial system and still pose an ongoing risk to any financial stability.

Leveraged speculation today is incredibly profitable – extremely low short term capital gains taxes and preferred tax treatment for option trading and margin debt expense. When middle income America is facing higher and higher taxes with fewer and fewer services, it is ironic they pay higher taxes than a trader of a hedge fund – and by a wide margin.

After WWII the typical short term cap gains tax was tied to the top marginal income tax rate, which was up to 70%. Under Reagan the top marginal tax rate dropped by nearly 50%. The cap gains tax difference between long term gains (investment held over one year) vs. short term gains (investment held under one year) decreased immensely (28% vs. 20%) making short term trading very, very profitable. There was no incentive to buy and “hold” since the tax rate difference was minimal.

On top of that Reagan’s tax changes up held the deductibility of margin interest expense (interest paid on borrowed money used to buy investments) yet deductions for credit card debt, auto debt, school debt, etc. were eliminated!! Again middle America saw their taxes go up while speculators benefited from lower rates.

By 1986 Wall Street had a tax code that mimicked the 1920s: extremely low cap gains taxes, available credit, and a new Fed. Reserve chairman who was not going to interfere with the big roulette table.
Right now, income from the riskiest transaction in stock trading – selling a put or call on a major market index (i.e. S&P 500) – is only taxed at 10%. This one example emphasizes how the US tax code supports speculation by giving the riskiest behavior the lowest tax rate.

The remedy?
1. Capital gains tax rate brackets based on length of holding period. When trades are held under one day, gains taxed at 90%. Graduate the tax down the longer the holding period, i.e. investment held over 10 years sees a tax rate of 5% for the first $100,000.

2. All derivative transactions (options, swaps, futures etc.) taxed at 80%, on both income and gains.

3. Eliminate the deductibility of margin interest expense.

4. Raise the Federal Reserve Margin Requirement (the amount of money the investor has to put up himself) to 80% for all investment classes (bonds, stocks, etc.). No exception for hedge funds, off-shore, FX, futures, etc.

5. Limit preferential capital gains and dividend tax rates (now at 15%) to only the first $100,000. Then establish new Federal gains/dividend tax brackets ($1.0 million, $10 MM, $100 MM, etc) where the highest tax rate reaches 75% as in the 1970s. This change would not only decrease speculation in the US financial markets, but it would start to shift the tax burden away from the middle class

Posted by Acetracy | Report as abusive

Until Obama chooses to raise taxes on what will be another record of Wall Street bonuses, nobody will believe he’s not in bed with the street

Posted by STORYBURNcom_0 | Report as abusive

[…] This post was mentioned on Twitter by allen_osuno and Yuz Asaf, Aviva O. Aviva O said: Until Obama raises taxes on obese Wall Street bonuses, nobody will believe he’s not in bed with the street | […]

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The US should realise that one eats humble pie when you are the under-dog.

Compare the yuan to other currencies at the same rate, see why it is like that, consider the 3.75 peg to the Saudi Riyal, yes 3.75, find a top rate and bracket the range in. How difficult can that be ?

Skip the reform and place the onus for (renewed) customer/taxpayer bail-out on the banks, not the State.

Turn wine into water, not water into wine.

Posted by Ghandiolfini | Report as abusive

Hi, Bro
I want you to put an eye on thai protesters because they will be a big crack down. The red shirt changing their color nw that mean the sign of losing.

Posted by tahanlaoboy | Report as abusive