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Why does the capital gains tax rate get applied to long term (> 1 year) stock holdings? This lower tax rate acts as an incentive for people to invest in the market for a period of time longer than 1 year. But why does the government care?

Why only long term investments? What do they care if I buy and sell shares in a company in the same year?

If the goal is to get me to invest my money, then why not give apply capital gains tax to my savings account at my local bank? Or a CD account?

If the goal is to help the overall health of business, how does it do that? During an IPO, the business certainly raises money, but after that I'm just buying and selling shares with other private shareholders. Why does the government give me an incentive to do this (and then hold onto it for at least a year)?

I know these are a lot of questions, but I mainly am just curious why we have a special capital gains tax rate applied to long term investments in stocks.

  • Based on the content of your question, I tagged this as 'united-states'. Other nations tax very differently. – ChrisInEdmonton Jun 8 '12 at 19:15
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Why only long term investments? What do they care if I buy and sell shares in a company in the same year?

Simple, your actually investing when you hold it for a long term. If you hold a stock for a week or a month there is very little that can happen to change the price, in a perfect market the value of a company should stay the same from yesterday to today so long as there is no news(a perfect market cannot exist).

When you hold a stock for a long term you really are investing in the company and saying "this company will grow". Short term investing is mostly speculation and speculation causes securities to be incorrectly valued. So when a retail investor puts money into something like Facebook for example they can easily be burned by speculation whether its to the upside or downside.

If the goal is to get me to invest my money, then why not give apply capital gains tax to my savings account at my local bank? Or a CD account?

I believe your gains on these accounts are taxed... Not sure at what rate.

If the goal is to help the overall health of business, how does it do that? During an IPO, the business certainly raises money, but after that I'm just buying and selling shares with other private shareholders. Why does the government give me an incentive to do this (and then hold onto it for at least a year)?

There are many reasons why a company cares about its market price:

  • A companies market cap is calculated by price * shares outstanding. A market cap is basically what the market is saying your company is worth.

  • A company can offer more shares or sell shares they currently hold in order to raise even more capital.

  • A company can offer shares instead of cash when buying out another
    company. It can pay for many things with shares.

  • Many executives and top level employees are payed with stock options, so they defiantly want to see there price higher.

these are some basic reasons but there are more and they can be more complex.

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It's a matter of social policy. The government wants people to make long term investments because that would lead to other long-term government goals: employment, manufacturing, economical growth in general.

While speculative investments and day-trading are not in any way discouraged, investments that contribute to the economy as a whole and not just the investor are encouraged by the lower tax rates on the profits.

While some people consider it to be a "fig leaf", I consider these people to be populists and dishonest. Claiming that long term social goals are somehow bad is hypocrisy. Claiming that short-term trading contributes to the economy as a whole is a plain lie.

  • I agree that it is a matter of social policy. I agree with your assessment that day-trading is not discouraged, just not incentivized by the tax code. The "fig leaf" argument can be considered separately. What I really want to know is how long term stock (in particular) investments "lead to... employment, manufacturing, economical growth in general?" During a company's IPO, it is obvious; the company receives a significant portion of the money raised. After the IPO though, how does buying and selling stock (long term or otherwise) from other stock holders benefit the company? – Jonathan DeCarlo Jun 8 '12 at 20:56
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    @JonathanDeCarlo long term investor participates in the company management in such way that the investment will remain valuable and growing. For example, long term investor will be able to sustain losses (for example for R&D expenditures) on paper, in order to cover them with later gains (when selling the results of the R&D - products, IP, new services). Short term investors don't have the patience, naturally, to invest, so instead they would want fast and furious revenue. For example, hostile takeover in order to distribute company's assets. That would not help the overall economy. – littleadv Jun 8 '12 at 21:03
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    Otherwise short term investors are merely speculating and are trying to gain profits based on the market fluctuations, instead of the underlying growth/value, which again doesn't help the economy as a whole. – littleadv Jun 8 '12 at 21:04
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Most well-off people have investments which they have held for long periods of time, often of very substantial value such as a large part of a company. They also have influence on legislators and officials through various social contacts, lobbyists, and contributions. They managed to convince these law makers to offer a lower tax on income derived from sales of such investments. The fig leaf covering this arrangement is that it "contributes to the growth of economy by encouraging long-term investment in new enterprises."

  • Consider example: I bought a house, and could have flipped it in 2 weeks for 5% profit. I would have paid ordinary gain tax rate. I decided to keep it, and sell it when the gain is taxed at long-term rates. What do I have to do now? Put the house on the rental market, invest in rehab and maintenance, and pay for services during the time I keep it. In the end, all the spending will be less than the tax gain, so I had profit and contributed to the economy. You tell me its a wrong thing to do, I dare you. – littleadv Jun 8 '12 at 19:02
  • @littleadv - Your house flipping example is valid, but my question is specific to "long term" stock holdings. Capital gains tax is applied to other types of profitable sales, but I can understand the benefit of those better. – Jonathan DeCarlo Jun 8 '12 at 20:46
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    Stock is a capital investment, you're investing in order to own property that provides revenue. What's the difference between owning a stock of a company that owns houses and owning a house? No difference. CD's are not taxed at long-term capital gain rates because its not a capital gain, its interest. Interest is an ordinary income, not capital. – littleadv Jun 8 '12 at 20:52
  • @littleadv - I see. I'll have to think about that a little bit more, but your argument seems sound here. Thanks! – Jonathan DeCarlo Jun 8 '12 at 20:58
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In Australia we have a 50% capital gain discount if you hold the asset for more than 12 months, whether it is in shares, property or other assets. The main reason is to encourage people to invest long-term instead of speculating or trading. The government sees speculation or short term trading as more risky than long term investing for the everyday mum and dad investor, so rewards people it sees taking the lower risk long term view. In my opinion, long term investing, short term trading and speculation can all be risky for someone who is unedutated in the financial markets, and the first rule of investing should be to consider the asset itself and not the tax implications.

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