Taxing Seed Corn — or the ‘Bailout’ Comes to Indiana

November 23, 2008

For release at noon Tuesday Nov. 25 and thereafter (765 words)

The implementation of the recent bailout legislation included a provision allowing the Treasury Department to invest up to $250 billion taxpayer dollars into bank equities in Indiana and throughout the country. This partial nationalization of our banks creates the potential for much mischief, calling up the old saying, “Taxing capital is like taxing seed corn.”

For example, the act provides restrictions on dividend policy, share repurchases and compensation policies of participating banks. Further, under the act, the government is issued warrants that will dilute the interests of existing shareholders and the Treasury will acquire voting rights to influence management in certain circumstances.

The effects of the 1990s version of the compensation restrictions illustrate the perversity caused by this populist aspect of the new law. It was Congress’ 1993 limitations on compensation that resulted in the options abuses of the “tech” era used to skirt the restrictions imposed by the law. 

The new bank compensation provision suffers from the same practical loopholes of the earlier legislation and, to the extent it actually curbs compensation, it will create an incentive among the most talented individuals to leave financial institutions for non-regulated companies, i.e., the B-team will be in charge of the public’s investment.

If, as some experts believe, additional rounds of capital injections may be necessary to fully re-capitalize the banks, a new administration and Congress could impose additional anti-market conditions on participating banks. The loss of economic freedoms can become a slippery slope toward further nationalization. And if this public injection of capital goes unchallenged, what troubled industry will be partially nationalized next?

All of this potential mischief can be avoided by injecting private capital into the banks and paying back the government as soon as reasonably possible. One means of accomplishing this result is a change in our tax code. New legislation would provide that there would be a capital gain rate of zero for gains from the sale of a new, secondary offering of stock in qualified financial institutions.  (A secondary offering is one in which the proceeds go to the bank rather than another selling shareholder.) The legislation could further provide that any capital loss incurred on the stock in the secondary offering would be allowed in an unlimited amount. (Under current law, capital loss deductions are severely limited for both individuals and corporations.)

The entrepreneurial investor will be given an incentive to seek out banks in which he has the best opportunity to realize a capital gain. Since this capital gain is taxed at a zero percent rate, the entrepreneur investing in a successful bank can expect to make a return far higher than alternative investments with similar risk characteristics. In addition, the unlimited deduction provision minimizes the investor’s downside risk, further encouraging him to make a calculated investment in banks.

This proposed legislation would inject new, private capital into the banks quickly. The power of meaningful tax incentives to impel swift action is demonstrated by Wells Fargo’s offer to purchase Wachovia a mere two days after a new IRS ruling making Wachovia’s loan losses readily available to offset the income of an acquirer.

Further, the proposal would identify the strong banks which can restart lending activities as opposed to weak banks that deserve to go out of business. The attractiveness of the new tax treatment would spur quick action by investors in strong institutions in which an untaxed capital gain is highly probable.  Conversely, the failure of weak banks to attract private capital even under such a tax-favored proposal will cast a spotlight on their impaired financial condition. This market-oriented approach is far superior to having the Treasury Department picking which institutions should survive.

One may reasonably argue that treating bank investors in a different manner than other investors is anathema to a flat, fair tax. Nevertheless, such treatment is far more appealing than a partial nationalization of an industry that is critical to economic growth. In short, America should not make the perfect the enemy of the essential.

The proposed tax legislation can be an example that can be repeated in other industries. In addition to fixing the lack of capital in the banks, this proposal can illustrate the desirable economic effect of the zero capital gains rate — or avoiding the folly of “taxing seed corn.”

Finally, Indiana can lead the way in promoting this legislation by providing similar legislation at the state level.  Though the state and county income tax rates are generally modest and thus the savings of the proposal for investors would be small, it would put Hoosiers squarely on the side of growth-enhancing free-market policies instead of a potential economic gulag.

Stephen E. Williams, an Indianapolis tax lawyer and certified public accountant, is a founding officer of the Indiana Policy Review Foundation.


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