The new tax law reduces the tax rate on long-term capital gains from 28 percent to 20 percent, which is good news for investors and the economy. It will encourage saving and investment, and ultimately raise real economic growth. Unfortunately, the benefits of a lower capital gains rate are partially offset by a lengthening of the holding period. Henceforth, investors will have to hold an investment for at least 18 months to get the 20 percent rate. Assets held less than that time may be taxed as high as 39.6 percent.

Further, the tax legislation establishes an even lower top rate of 18 percent on capital gains for assets acquired after December 31, 2000. But to take advantage of this opportunity assets will have to be held for at least 5 years.

The 18-month and 5-year holding periods apparently were added to the tax bill at the behest of the Treasury Department. The idea is to dampen speculation by discouraging rapid turnover of assets, and encourage long-term investing. However, there is no evidence in the economic literature that speculation is destabilizing, or that longer holding periods discourage speculation. In fact, there is growing evidence that speculation stabilizes prices and that long holding periods misallocate investment.

The bias against stock speculation appears to be based on a misconception, equating speculation with manipulation of the market. This is what led Congress to include a 2-year holding period in the first capital gains legislation in 1921. However, today's financial markets are far more regulated and closely supervised. The kinds of manipulations that concerned Congress back in 1921 are a thing of the past.

To economists, the term speculation has no negative connotation. It simply connotes trying to buy low and sell high. In this sense, speculation helps stabilize prices, as speculators bid up prices at the bottom of the market and dampen prices at the top of the market. Thus as economist Milton Friedman notes, the only way speculators can destabilize markets is by being systematically wrong -- buying at the top of the market or selling at the bottom, rather than the reverse.

Another misconception is that there is some special virtue in encouraging long-term holding of financial assets. This results from confusing investments in tangible capital, such as machinery and equipment, with investments in financial capital, such as stocks and bonds. While it may well be economically sound to encourage long-term investments in tangible capital, there is no logical reason why long-term investment in financial capital will yield the same results.

Indeed, holding periods may actually misallocate investment by causing stock prices to diverge from their fundamental values.

• Holding periods may reduce sales of stocks, causing prices to be too high, explains James Repetti in the Winter 1989 Virginia Tax Review.

• They may also reduce some prices below fundamental values when stock sales are bunched at the end of the holding period.

• To the extent that stock prices diverge from those that would occur in a rational market, it leads to misallocation of capital that can reduce economic growth.

In 1982, Senator Daniel Patrick Moynihan (D-N.Y.) introduced legislation to abolish the holding period for capital gains altogether. As he explained, "A powerful case exists for leaving investors free to move their capital about in search of the highest return....People are reluctant to shift their funds to more productive uses if they must wait to take advantage of the capital gains rates on their current investments. The capital markets become distorted. Capital is used relatively inefficiently."

Lengthening the holding period for capital gains to as much as 5 years was a mistake. It should be repealed at the earliest opportunity.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, August 6, 1997.