Put Pain Into Profits Made in Short Term

Suddenly, in the spreading wake of the Wall Street scandals, a cure is being offered for that virulent and debilitating disease of American business called the short-term focus.

Everybody knows the problem: Even as their global competitors plan investments in terms of decades, American corporate managers seem to have no more farsighted objective than keeping quarterly earnings rising and the stock price from falling.

Everybody blames the system: Corporate executives decry the pension funds, which control roughly 50% of the stock of major U.S. companies, for selling out at the first sign of an earnings decline or the first offer from a corporate raider. The pension fund investment managers, in turn, blame the corporate executives who, as trustees for their companies’ pension money, grade money managers’ investment performance each quarter.

Is there a way out of the bind? Yes, say some prominent financial minds: Simply shift the incentive to long-term investing by taxing the short-term trading profits of pension funds and other investing institutions that are now exempt from taxation. Allow the institutions to retain tax-exempt status for profits made on investments held for several years.

100% Tax Proposed

It is an idea proposed in several forums recently by such sophisticated business people as investment banker Felix G. Rohatyn, managing partner of Lazard Freres & Co., who suggested in testimony before the Senate Banking Committee that Congress consider taxing institutional trading in “inverse proportion� to how long stocks or bonds are held. Perhaps, says Rohatyn, “tax investments sold in a month at 20% and those held for three years at zero percent.�

Warren Buffett, director-owner of Capital Cities/ABC, and one of the nation’s most successful investors, was harsher in a recent essay in the Washington Post, advocating that the government “impose a 100% tax on any profits made from sale of stocks that the holder has owned for less than a year.�

Serious problems demand serious measures, says Charles Ellis, managing partner of Greenwich Associates, a leading adviser to pension fund trustees. Ellis wrote to his customers that short-term trading profits should be taxed because “pension funds--quite unintentionally--may have become one of the devil’s engines, causing our economy to turn its strength against its own best interests.�

When the pension funds, which today control $2 trillion in capital, were set up in 1951 nobody thought they would become devil’s engines. It was assumed they would be stable, farsighted investors simply because their mission of earning income to meet retirement obligations is long-term. But they turned out to be just the opposite, trading 70% of their portfolios every year and investing in options and futures in a vain quest for performance. Ironically, pension fund investors almost always underperform the market--in part because transaction costs on all that trading eat into investment gains.

Worm Has Turned

But criticisms of their trading have been shouted down in recent years by corporate raiders and investment bankers, who argued free markets even as they pocketed fortunes--lawfully and otherwise--and by addled university professors who ignored the uncompetitiveness of U.S. business and saw the chaos in our markets as all for the best, in the best of all possible worlds.

Now the worm has turned. With investment bankers discredited and legislative hearings on takeover curbs being held in Washington, the emphasis is shifting. It becomes intelligent to ask, as former Labor Department pension administrator Robert Monks did years ago, whether public policy shouldn’t discourage pension funds from chasing short-term performance. Putting the incentives on long-term investment would do a lot of good, says Monks today. “It would re-establish the responsibilities of management to real shareholders, and at the same time affirm pension investors as real shareholders, whose interest lies in the long-term health of the enterprise.�

Great and noble thoughts, but does a tax on trading have a chance? “Timing is everything,� says Rohatyn, who notes that Speaker of the House Jim Wright (D-Tex.) has just proposed a tax on securities transactions to help finance the government’s budget deficit. Rohatyn’s point is that shrewd politicians like Wright sense when change is possible, and the Wall Street community, shown now to have been everywhere shortsighted and greedy, and in significant quarters downright dishonest, is ripe for change.

Outrage from the brokerage industry greeted Wright’s proposal, as it will undoubtedly attack the tax-on-trading idea. But if Congress is smart it will ignore the outrage, as predictable as it is boring, and listen to the quiet but influential voices who are saying we’ve got to do something about the short-term orientation of U.S. investing. The time has come.