Congress Helped Fuel Wall Street’s Crazy Ride

By Kathleen Gallagher

This is not about a Twitter moment between Rep. Alexandria Ocasio-Cortez and Sen. Ted Cruz. Or the winners and losers when GameStop, Koss, Tootsie Roll and other stocks took their wild ride at the Wall Street carnival.

This is about the majority of Americans who are losing while Wall Street has its way with our economy and our future. And it's about Congress encouraging financial inequality.

The Federal Reserve has flooded our economy with money, sending the stock market and Wall Street profits soaring. That's opened the door to a wild party where crazy things happen, like a dramatic upswing in the stock of GameStop, a dying retailer that sells products in a dying format called video.

Bill Nasgovitz of Heartland Funds nailed it in a recent commentary: "...a champagne market that's dizzying, expensive, full of bubbles and destined to lead to a painful hangover."

"The Fed's tools have much more impact on the financial economy," said Willie Delwiche, investment strategist at All Star Charts, an investment research service. "But it's Congress that can impact the real economy."

Congress' ability to do that starts with taxes. A fundamental tax principle says you get less of what you tax and more of what you subsidize. We tax cigarettes to encourage less of them and subsidize agriculture to encourage food production.

Things get trickier when similar activities are taxed unevenly. The Catholic Church owned about one-third of all the land in Europe in the Middle Ages because it was the only entity the government couldn't tax. Taxing one part of the economy disproportionately less over a long period gives it a path to owning a big chunk of the economy's assets.

What our government isn't fully taxing is investment profits - like the capital gains made on Wall Street. The effect of this tax break is that the rich keep getting richer.

If you're in the top 37% bracket, you only pay 20% of any long-term investment gain - nearly 50% less - to Uncle Sam. That differential adds up over time - just like it did for the Catholic Church.

In the 1970s, Congress put tax laws and regulations in place - including lower capital gains tax rates - that tilted incentives toward the stock market. Since then, it has tilted the incentives more by reducing the minimum holding period to one year for long-term capital gains.

The wealth gap has widened ever since. And the Fed has been fighting wave after wave of Wall Street's irrational exuberance and excessive risk-taking, engaged in by a widening population of our best and brightest who know an unfair advantage when they see it.

There are only two good reasons to allow lower taxes on capital gains: To promote long term investment and to encourage technological innovation.

If Congress wants to do that, it's silly to say capital investment and innovation happen in a year, the current holding period for a long-term gain.

In the real economy, it takes more than a year to do the work - like securing financing, building out the property, buying and installing equipment - around a factory expansion.

Same with technological innovation. Whether it's genetic engineering, artificial intelligence or autonomous vehicles, it typically takes at least five years, often much longer, to commercialize products and services. It took Steve Jobs, and all the people making relevant advances, much longer than a year to develop the iPhone.

Current tax law is encouraging a lot of bad behavior, mostly associated with Wall Street.

For example:

Wall Street firms buy late-stage, venture-backed companies that would normally go public and flip them a year later into the public markets to benefit from preferential capital gains tax treatment.

Private equity players buy established businesses, reduce costs, shed workers and eliminate corporate investments so they can flip them quickly and get capital gains profits. If they didn't get preferential tax treatment or if the holding period were longer, this strategy wouldn't work so well. Financial engineering only works over two or three years, then the value of the company typically declines.

Public company executives make stock options a bigger part of compensation knowing they can get preferential capital gains treatment on them. This encourages corporate borrowing to buy back shares, which pumps up earnings and increases the value of the executives' options.

Wall Street's true genius has been to convince our elected representatives anything that's good for Wall Street is good for the country.

Time after time we bail out Wall Street's reckless behavior by socializing its losses - $7 trillion on the Fed's balance sheet so far. Attempts to unwind that, euphemistically called tapering, spark outrage.

In theory, the financial services industry should be the ballast that steadies our economy through its normal ups and downs. Instead, it has become a flashpoint that could suddenly collapse and send the economy into a tailspin.

Wall Street is too highly leveraged with off balance sheet transactions designed to capture capital gains tax treatment to be a buffer on economic cycles. Wall Street professionals who reap huge compensation payments have loaded capital markets like a spring gun that goes off when slight abnormalities occur.

It's time for Congress to get its head around this problem and fix it.

Kathleen Gallagher was a business reporter at the Milwaukee Journal Sentinel and the Milwaukee Sentinel for 23 years. She was one of two reporters on the team that won a 2011 Pulitzer Prize for the One in a Billion series. Gallagher is now executive director of 5 Lakes Institute, a nonprofit working to grow the Great Lakes region's high technology entrepreneurial economy and culture. She can be reached at Kathleen@5lakesinstitute.org.