With the call for capital gains tax increases making the rounds, investors would be very reasonable to wonder what effect an increase would have on their portfolios. Obviously an increase would mean that you would receive less money when you sold a stock at a gain. An increase in the gains rate, however, would immediately affect the stock market, causing a drop in prices. Ironically, the effect of that drop may be to cause additional losses to be realized, resulting in the amount of capital gains and ordinary income taxes to actually go down.
To understand why stock prices would fall, you need to understand risk/return ratios and the market pricing system. First we’ll discuss risk and reward.
All investments have risks and potential rewards. The greater the risk, the greater the potential reward that is required for investors to place their money in it.
In a bank account, the rate of return is virtually guaranteed (to see why it is only “virtually” guaranteed, see the bank crash of the Great Depression, the S&L crisis of the 1980’s and the recent bank collapse in 2008). If you put $100 in a bank CD at 1% interest, you would expect to have $105 in the account at the end of the first year. There is almost no risk, and therefore the return can be fairly small.
With common stocks, a lot of the return comes from capital gains. Capital gains, in turn, are due to price increases, which are caused (at least in the long-term) by earnings growth. As earnings grow, even if the company does not pay a dividend, it has the potential to pay a bigger dividend in the future. Therefore, investors are willing to pay more for the stock.
Earnings for a company, however, are in no way guaranteed. Earnings depend on a lot of factors, most of which are difficult to predict, especially a few years out. The price of a stock therefore is based on the current earnings and expectations of future earnings, discounted by some amount to account for risk. (Discount in this case is a fancy financial term meaning that the price is lower than it is expected to be in the future, assuming a certain return). The more uncertain the future earnings, the greater will be the discount.
This makes perfect sense if you think about it. If you loaned someone $1000 whom you were sure would repay you, you would probably not require much interest if any. If a person who you know stiffed you or a friend in the past asked you for a loan, you would not make it unless that person offered to pay you back substantially more for the risk. Maybe you’d require $2000 back in a month, with payments each week, if you only believed the chance of being repaid was only 50-50.
With stocks, if one thinks that the chance of actually making the expected earnings in a year is 50-50, you might not be willing to invest unless you thought the stock would increase by 30% if the earnings target is met. You would therefore not pay more for the stock than 30% lower than the expected value if the expected earnings are made. This means that in exchange for taking the risk, you expect to get a 30% return. If you buy four such stocks, you’ll make 30% on two of them and break even or lose money on the other two, assuming they follow the odds exactly. This means you would receive a greater return than you would with a bank account. If you were only going to receive a 1% return and the bank was paying 1%, you would just stick your money int he bank and not take the risk.
Note that the expected price if earnings are made can be predicted fairly reliably by looking at past Price- Earnings ratios (PE). Because stocks typically trade in the same PE range, you can do a reasonable job of predicting the price range by multiplying the expected future earnings by the low and high values of the range. You could also use Price-Sales ratios (PS) in cases where the stock has no earnings or negative earnings at times.
So how do you know that you are paying the right amount for a stock? Luckily, you don’t need to calculate the earnings risk because the market does that for you. By constantly trading, stock prices are continuously adjusted based on new events and changes in the fundamentals. While prices may diverge for short amounts of time due to various trading schemes being employed, they will always eventually return to a reasonable price given the risk.
Now back to the effect of capital gains tax increases. The effect of taxes is to lower the return one receives. In order to once again provide the needed return for the given risk, share prices would need to decline by a like amount. This means that the price of stocks will go down as soon as tax increases are expected.
How much will it go down? Well, the profit will be reduced by the percentage increase in taxes, times the expected rate of return. For stocks, a 15% return is a reasonable number (although the return will vary depending on how volatile the stock is). Using 15% return, the following are predictions of the effect of changes in the capital gains rate:
New Rate Average %Change in Price Expected change in 11,000 DJIA
20% -0.75% -$82.5
35% -3% -$330
90% -11.25% -$1240
While the change is not that large compared to other effects, taxes collected could be reduced by a substantial amount. Assume that the US market capitalization (the current value of the stock market) is about $50 Trillion, as it was in August of 2008. The amount of wealth destroyed by the different market changes is shown below:
New Rate Average %Change in Price Market Loss Tax Reduction
20% -0.75% $37o B $75 B
35% -3% $1.5 T $300B
90% -11.25% $5.6 T $1.13 T
So, if taxes were raised to 90% for capital gains, as some are proposing, taxes collected would actually be $1.13T less than expected, just because of the drop in stock prices that would result. This doesn’t take into account people not investing at all because the taxes were so high. This would affect both capital gains and the availability of jobs.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.