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Kass: Current Fears Are Overblown

Stocks in this article: FBPGSPY

It is my expectation that both parties will likely move toward the center in the fiscal cliff negotiations and will reject the more extreme members of their respective parties in making concessions to each other.

The fears of a deep fiscal cliff are overblown.

Don't Worry About Taxmageddon

At the current time (and until Dec. 31, 2012), income derived from capital gains and dividends is taxed at a maximum rate of 15%. If Congress fails to act, the capital gains tax rate will rise from 15% to 20%, and the top dividend tax rate will more than double from 15% to 39.6%.

On Jan. 1, 2013, investment income will be subject to an additional Medicare hospital insurance tax rate of 3.8%, which will raise the top rate on dividend income to 43.4% and on capital gains to 23.8%.

How Meaningful Is the Market Impact of Rising Taxes on Capital Gains and Dividends?

For the purpose of argument, I am going to assume that the tax on dividends rises from 15% to 25%, as the Obama administration has indicated this is the desired level.

Let's be conservative and assume both the tax rate on dividends (up to 23.8%) and on capital gains is 25% in 2013.

Here is my calculus (and logic) behind why I believe these proposed tax rate hikes will have only a limited market impact.

  • Assuming the tax rate on capital gains and dividends rises from 15% to 25%, 1.00 less the change in tax rates (15% to 25%) is 0.85 and 0.75 -- 0.85 divided by 0.75 is 13.3%.
  • Assuming all investors are taxable, stocks would decline by 13.3%, but only 20% to 25% of trading is in taxable accounts -- -13.3% multiplied by 22.5% (20% to 25% above) equals 3.00%.
  • Assuming all investors in taxable accounts act on the higher tax rates, stocks would decline by -3%, but all investors will not act on the tax rates increase, so the impact on stocks will be something less than -3%. (Credit Suisse's Garthwaite estimates the dividend and capital gains hike will reduce stock values by 2.5%.) How much less? I estimate at about only 1% (see below) -- in other words, a negligible impact (despite current investor fears).

I have a number of reasons why I take down the 3% impact to about only 1%, suggesting the fears of a tax-rate cliff (on dividends and capital gains) are overblown.

  • Most individual taxable investors have long holding periods. The longer their investor perspective the less likely they will sell, even if tax rates are rising (and the less consequential the aggregate impact on the markets).
  • Most really long-term investors would prefer not to sell at all and not to incur any tax.
  • Many investors don't have capital gains.
  • The distribution of unrealized gains is probably uneven. For example, the original investors in Facebook (FB) do have a huge decision to make -- not so much if you are an individual investor who paid $65 a share for Procter & Gamble (PG), which is now trading at $67 a share.
  • The calculation above assumes something of an equal level of sophistication -- we all know that isn't the case. My guess is at least 50% of all taxable investors don't even know the capital gains and dividend tax rate is rising.

I have two other observations:

  1. I don't recall any good buy/decision I have made based solely on taxes; I suspect others have had a similar experience.
  2. Those who are selling high-dividend stocks (usually conservative or older investors) to take advantage of the change in the dividend tax rate would have particularly low propensity to sell. Why sell, pay taxes? How will they replace yield?

My bottom line is that far less than 50% of those taxable investors (probably closer to 25% at most) will take advantage of lower taxes in 2012 and sell before year-end.

At 50%, the aggregate market impact is about a 1.65% reduction in value of the U.S. stock market (50% of -3.3% equals -1.65%). If 25% of taxable investors sell, the aggregate negative impact on equities is only 0.825%.

Stated simply, these fears are overblown.

The Geopolitical Cliff Is Ebbing

It appears that the risk of an air strike by Israel on Iran's nuclear facilities has been recently reduced. Sanctions have already hurt Iran's economy. Social unrest has accompanied rapid inflation and a currency that has depreciated by nearly 50%.

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