In his column this morning, Max raised the spectre of a capital gains tax to take care of an overheated stock market. There has already been a good discussion of this on Ticker Talk, but I think some further analysis will be helpful.

What is a capital gains tax? In the real world, when you buy something, like a house, a bond, Action Comics #1, or a stock, and it goes up in value, and you subsequently sell it, you are required to pay a capital gains tax to the Feds on the difference between the buy and sell price. The logic behind the tax is that capital gains are income like any others, and should be taxed similarly. (I happen to agree with this logic and think capital gains taxes should be identical to income taxes, although their rates are currently lower, but this is a side issue). Wages and interest payments from bonds and savings are counted as income for tax purposes.

What would an HSX capital gains tax look like? Max mentioned taxing all capital gains made on accounts since the HSX year started on January 16. Since it is unlikely, and a lot of work, to determine which gains came from interest payments and which gains came from stocks, they would probably just look at your ytd percent, use it to calculate the dollar value of gains, and multiply it by a 20% tax rate. This is not a given, it is possible they would deduct interest payments first, but this will have a negligible impact. It is also possible that they will deduct “unrealized” capital gains from your account – gains made, but not cashed out yet. This could have a serious impact, as any gains that are currently unrealized would become a tax shelter.

What impact would a capital gains tax have on the game? Few that are significant. Since people are likely to be affected in direct proportion to their portfolio size, most accounts will be affected very similarly, leading to very few leaderboard changes. The exception would be accounts that existed before January 16 and have grown at different rates since. For instance, Richard Merino’s Lifetime Account will likely pay more tax than my lifetime account, since he has made more than me this year (maybe this tax isn’t such a bad idea). Other impacts will be on the MTD board, where newer accounts will be hit less than older accounts. The important thing to note is that the tax itself will have no impact on stock prices. Prices are affected by buy and sell orders, and if money is removed from account without it buying or selling something, prices won’t change. This is an important point since the stated purpose of the tax is to calm inflation.

So what should I do? Sit tight. If you do sell off, you may end up creating realized capital gains and increasing your tax burden. Also, since a capital gains tax is wildly unpopular on Ticker Talk due to the summary nature of the annoucement, and since the tax will not meet its stated objectives, I suspect this idea will go the way of many other ideas on HSX and die a deserved death once Max gets the feedback he was looking for. HSX generates lots of ideas, some of them very good (the idea for the exchange in the first place, options, etc.) and some of them bad (Oscar bonds, the Founder’s cup bond bonanza, etc.) I think it is our duty to point out to them which ideas are which, and hope they listen.

What about inflation? HSX has several other tools at their disposal to counter inflation, and can use them if they choose. I also am not sure that the stock market is indeed inflated (stocks have not been very overpriced, mild arbitrage still exists, and several upcoming stocks are way underpriced).

In summary, don’t panic, and use the current sell off as an opportunity to spot excellent deals.