Taxes and the Stock Market

David R. Kotok
Chairman and Chief Investment Officer
Taxes and the Stock Market
July 22, 2010

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If you want less of something, tax it. If you want more of something, do not tax it.

We ask the next question with that principle in mind. Could the two-month stock market malaise be due to the forthcoming hikes in the income tax rates on dividends? Or on capital gains? Or both?

The capital gains debate is simple. The rate on long-term gains will be 15% for 2010. Twenty percent may be the rate if the Geithner comments become a reality. Alternatively, it could become anything else, depending on Congress.

Geithner has said the White House will let the Bush tax cuts expire. He also said the Obama administration wants a 20% tax rate on dividends and on long-term cap gains. Therefore, the tax fight will be conducted in the lame duck session that follows the November election.

The conclusion that cap gains will either go up or stay the same is a virtual certainty. Hence, markets could be seeing some selling pressure as investors take gains in 2010 with a known tax rate of 15% rather than wait and deal with the uncertainty.

Since the market started its rally in March 2009, more and more individual stock holdings become long-term as the calendar progresses in 2010. We are in mid-July now. Large long-term cap gains exist in the hands of buyers of stocks who positioned them from March 9 through the balance of last year’s bull market. The sales of gains and the offsetting of losses were active as portfolios rebalanced with tax efficiency in mind. June and early July could easily have exacerbated the selling pressure that started in May.

In this commentary, we are ignoring state taxation of cap gains for simplicity. Many states tax the gains as ordinary income. Then there is the complex issue of federal deductibility of the state income tax and the trigger of Alternative Minimum Tax (AMT). In addition, the cap gains affect the AMT calculation, which means they could crowd out other items and force them into higher tax brackets. Enough. Thank your congressional representative for this one every time you see him/her.

Dividends.

Strategas Research and the Tax Foundation helped on this issue. They compared the net dividend that gets to the shareholder from a “C” corp. by starting with $100 earned at the corporation level. In both 2010 and 2011, they assumed the federal and state corporate tax would combine at a rate of 39.1%. That left $60.90 of net corporate earnings available for the dividend from that corporation to the shareholders.

In 2010, the shareholder paid a 15% tax rate on the dividend; the cost is $9.14. Strategas assumed a net state tax rate of 2.25% or $1.37. Combined state and federal taxes cost the shareholder $10.50. That left the shareholder with $50.40 of the corporation’s original $100 earnings. The effective tax rate on that $100 of corporate earnings is 49.6%.

In 2011, there is the potential for a dramatic change if the Bush tax cuts are allowed to expire. The initial $100 would be taxed the same at the corporate level. As in 2010, there is $60.90 left after state and federal corporate taxation.

Federal dividend tax rates will be 39.6% unless there is congressional action. That is a $24.12 tax. State taxes on the dividend are assumed at a higher rate of 3.3%. That equals $2.02. The Medicare tax will apply at a 3.8% rate; this is another $2.31. Thus, the total taxes are about $67.60. The shareholder ends up with $32.40 of the original $100 in earnings.

This could change if the Geithner proposal to tax dividends at 20% becomes law. Dividend taxes would still go up but not as much as currently projected. Remember: it takes a tax bill initiated by Congress to get the dividend tax rate to something under the 39.6% scheduled for next year.

Besides, the temporary damage done to stock values from this prospective dividend tax hike, we can also consider what behavioral changes may occur. Those small businesses that are able to make elections will be greatly encouraged to use S corp. status or the LLC structure. There will be less incentive for newer businesses to become public companies.

Some C corporations may elect to borrow and deduct the interest and use the proceeds of loans to buy back their stock. That is bullish for stock prices over time since it reduces the supply of tradable shares by retiring them with these stock buybacks. Companies see this as more advantageous to their shareholders than paying dividends. That is what happens when there is a gap between dividend taxation and capital-gain taxation.

Tax policy can affect stock market pricing. Resolution of it adds clarity and allows courses of action to be selected with certainty. Will Congress give us that answer quickly? Not likely. This same Congress left us the present mess with the estate tax. Why should we expect anything different?

Whenever this tax issue is resolved, we expect the cloud of taxation uncertainty to lifted from the stock markets. Markets will be higher, since these tax uncertainties only bring about a temporary selling pressure. Our best guess is that stocks are up in 2011 after the tax situation gets clarity. We continue to look for the US stock market to close the Lehman Gap. Out target for the S&P 500 index remains 1250-1300.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com