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A Taxing Issue for Investors

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- The 2012 elections hold major consequences; one of them is tax policy. While there is much that we could present regarding the potential changes, we will constrain our comments to how tax changes may directly affect investors in the stock and bond markets.

Already written into law for 2013 are big changes including the expiration of the Bush tax cuts and the payroll tax cut and the new Medicare tax on investment income, not to mention the impact of the increasingly costly annual fix to the alternative minimum tax. However, this default option may instead be replaced by something else.
  • President Obama has devoted a lot of his recent campaigning to highlighting his preference for the so-called "Buffet rule," which places a top minimum tax rate on capital gains of 30% and, combined with other changes, produces a top rate of 43.4% on dividends and interest income.
  • Alternatively, included in the Mitt Romney supported House Republicans' proposal is a cut to the top income tax rate that would apply to interest income to 25% and maintain the 15% rate on dividends and capital gains.
  • The outcome is likely to be somewhere in the middle of the wide range between these two proposals. Given the scale of the changes, it may be surprising to note that we do not expect major direct impacts of tax changes on the stock or bond market. The far bigger impact is an indirect one determined by the magnitude and direction of overall fiscal policy taken (or not taken) in 2013 to put the United States back on a path to financial stability.

    Bond Market Tax Rate Impacts

    Historically, changes in income tax rates that apply to interest income appear to have had little, if any, direct impact on government bond yields. Yields rose with inflation in the 1970s and fell as inflation fears receded over the vast majority of the last 30 years regardless of tax code changes or their impact on the deficit.

    Over the past 30 years, municipal bond yields traditionally traded at a discount to taxable bond yields. However, in recent years credit fears driven by macroeconomic events have resulted in a breakdown of the historic spread between taxable and non-taxable municipal bonds. Municipal bonds now trade at yields in line or above those of their taxable Treasury counterparts. The potential for higher income tax rates applied to interest income is likely to make municipal bonds even more attractive to investors as credit fears fade.

    Stock Market Tax Rate Impacts

    Tax changes have also had minimal effects on stock market performance. To illustrate, we can look at the two most important drivers of stock market return: earnings growth and valuations.

    Generally, higher taxes mean less of an incentive for individuals to work, invest, take risks to create value and become entrepreneurs. It can also mean less disposable income to spend on goods and services. However, income tax changes have not had much measurable effect on earnings growth.

    Earnings growth is very cyclical -- it falls sharply during recessions and rebounds early in expansions to average about a 7% growth rate over the full cycle. This has been consistent regardless of the prevailing tax rates. In fact, the growth rate of earnings from the peak of one business cycle to the next has consistently been about 7% over the six major earnings cycles spanning the past 50 years, despite average top marginal income tax rates that ranged from 91% at the beginning of the period to the current 35% and corporate tax rates that ranged from 52.8% to 34%.

    Earnings and Taxes

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