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If the tax rate on capital gains — the profit made on investments — jumps by two thirds next year, we can expect the stock market to take a beating. Maybe the economy will, too, since ordinary income tax rates also are scheduled to increase by 28% or so. This time bomb will go off unless Congress and the President agree on some way to defuse it. Because action must be taken before year-end, it is the existing Congress and President — the same crew that failed to see eye to eye last year — not the ones that will be elected in November. There always is hope, but the Bipartisanship Fairy hasn’t been around much lately. It isn’t difficult to imagine the market sell-off if the capital-gains tax rate moves to 25% next year from 15% this year. Suppose you had a $100,000 “paper profit” in stocks. If you sold in 2012, you’d keep $85,000. If you sold in 2013 you’d retain 12% less, or $75,000. What would you do? It would be worse if this sell-off occurred within the final weeks of the year. The election is over, and everybody hopes Washington can devise a plan to reduce the federal deficit without imposing stiff tax increases. But then November slips by without any progress. Some people get nervous and start selling. Others notice the move toward the exit, so they sell, too. Soon the rush is on, and the damage is done even if a last-minute solution is found. The influence of taxes on stock prices is most noticeable when the taxes are first levied or are substantially changed. After those events, the market quickly moves on to digest the next bit of new news. In so doing, some observers have concluded, the market demonstrates long-term insensitivity to such matters as taxes and tax rates. This view is not valid. The market’s diverted attention to other matters does not mean the tax environment then ceases to have any effect on market action. Taxes and tax rates become woven into the fabric of real-life considerations that are taken into account by people making investment decisions. In 100 years since the Sixteenth Amendment authorized the federal government to tax income, the maximum rate on capital gains has averaged 26.4%. That average was inflated by maximum rates of 70%-plus during World War I and its aftermath, so let’s use 25% as the midpoint. From 1913 through 2011, there were five periods totaling 63 years in which the maximum capital-gains tax rate was equal to or less than 25%. For that block of years, the Dow Jones Industrial Average — the only U.S. stock market index published continuously during this time — posted an annualized gain of 6.05%. In the 36 years during which the maximum rate was greater than 25%, the DJIA gained 3.49% annualized. The overall annualized return from 1913 through 2011 was 5.11%, which makes the 6.05% return 94 basis points above the historical average, while the 3.49% return was 162 basis points below. This asymmetry means the DJIA performance was constricted more in the high-tax years than it was enhanced in the low-tax years. To be clear, these data do not demonstrate or imply a cause-and-effect relationship between capital-gains tax-rate levels and DJIA performance. Given the time spans involved, any attempt to do so would be ridiculous. On the other hand, these data were not “mined,” either. The historical DJIA performance was carved into pieces related to tax-rate levels established by acts of Congress. While these acts did not occur randomly, they were taken in response to conditions other than, or at least in addition to, stock-market performance. Moreover, the timing of these acts was largely asynchronous with generally recognized stock-market cycles, which adds credibility to the results. The lesson here is that tax rates do seem to have exerted a lasting influence on the stock market, not just a temporary disturbance. That means attempts to fix the government’s debt and deficit problems should not be geared solely to wiping them out as rapidly as possible. Instead, the wiser approach would be to strike a balance between remedies that are effective in the near-term but don’t engender regrettable long-term consequences. This article originally appeared on Forbes.com on April 8, 2102.
2012 Economic Growth Fellow
John Prestbo is retired as editor and executive director of Dow Jones Indexes. Previously he was markets editor at The Wall Street Journal. He has co-authored or edited several books over the past 30 years. The most recent is “The Market’s Measure: An Illustrated History of America Told Through the Dow Jones Industrial Average,” published in 1999 by Dow Jones Indexes. His column, Indexed Investor, appears on the highly regarded “MarketWatch” business and finance website. He received his bachelor's and master's degrees from Northwestern University.Full Bio