Some Economists Doubt Dire Effects From Tax Increases

Mr. Kass, the founder of Seabreeze Partners Management, thinks much of the investing world has overestimated how hard the markets and investors would be hit if tax rates on dividends and capital gains rise at the end of the year, as the White House has proposed.

Mr. Kass can look for support to several economists who have studied past changes in tax rates and found that the shifts had less of an impact on investor behavior than was initially expected.

That’s largely because a dwindling number of investors are subject to the taxes on investment gains that are set to rise at the end of the year, with most stocks held in accounts that are exempt from taxes.

For example, only 14.7 percent of American households have mutual funds in taxable accounts, down from as high as 23.9 percent in 2001, according to data from the Investment Company Institute.

Douglas A. Shackelford, an economist who has examined the 2003 legislation that lowered the tax rates on capital gains and dividends, said that when those changes were being put in place “people thought this would be revolutionary,” setting off a wave of changes in the way companies rewarded their investors, and how investors evaluated companies.

In the end, “it made a difference, but it certainly was not revolutionary,” said Mr. Shackelford, a professor of taxation at the University of North Carolina’s business school. The limited number of investors who were subject to the changes in 2003 has grown even smaller today, he said.

While data on the tax status of all stockholders is hard to come by, many economists agree than an increasing proportion of the entire equities market is now held by retirement investors whose holdings are not subject to current tax law; by foreign investors who don’t pay American taxes, or by institutional investors like insurance companies and pension funds that are exempt from taxes.

Sam Stovall, the chief investment strategist at SP Capital IQ, said that even among individual investors who do pay the taxes, many have incomes under $250,000 and would not be subject to the increased rates on investment income proposed by the White House. The result Mr. Stovall is anticipating is that the coming changes will cause “a lot less of a hit than most people are making it out to be.”

Mr. Stovall and others who share his views are not discounting the potential disruption to the financial markets if the White House and Congress fail to reach any agreement on the broad set of tax increases and spending cuts scheduled to hit at the start of the year. The largest of these changes are not on investment income. An increase in the payroll tax, for example, could remove $95 billion from the take-home pay of Americans.

But even if a broad agreement is reached, many strategists are expecting that taxes will rise on investment income, with the White House proposing that for households earning over $250,000 the rate on dividends rise to a peak of 39.6 percent from the current 15 percent, and the rate on capital gains increasing to 20 percent from 15 percent.

Wealthy households will face an additional 3.8 percent charge on most investment income to help pay for the recent health care legislation.

Neil J. Hennessy, the founder of Hennessy Funds, said at a year-end investing event last week that if politicians allow the rates to rise as much as the White House has proposed, dividends will become much less attractive and there could have a “disastrous effect” on the willingness of investors to put money into stocks.

Some companies have already acted ahead of the changes, with Costco and Las Vegas Sands leading the way in issuing special dividends before the end of the year so their shareholders can take advantage of current tax rates. Some investors have sold off stocks that issue regular dividends expecting the companies to become less valuable once a greater proportion of dividend income is lost to taxes.

Andrew Garthwaite, an analyst at Credit Suisse, has predicted that if the White House’s view on investment taxes prevails, it could lead to a long-term reduction in the value of the Standard Poor’s 500-stock index of as much as 5 percent. Mr. Garthwaite cautioned that the figure is likely to be lower, and that investors have already incorporated some of those losses into the market by selling stocks.

Mr. Kass disputed Mr. Garthwaite’s estimates in a note to clients, and said he was looking at market losses of at most 1.6 percent and more likely closer to 0.8 percent. Part of the disagreement arises from Mr. Kass’s contention that many people who are subject to tax are either uninformed about tax law — and unlikely to respond to changes — or more focused on the long-term performance of their portfolio than on short-term tax payments.

Mr. Kass said that even the losses he has predicted assume that wealthy people will be willing to cash out of their stock positions and stay out, something that he said is unlikely given the small returns available in other financial investments.

But an even larger source of misunderstanding has come from the difficulty of ascertaining the amount of all United States stocks held by people who will have to pay the new, higher tax rates. Foreign investors controlled 12.4 percent of American stocks in 2011, up from 8.8 percent in 2004, Treasury Department data shows.

Among the stocks that are held in the United States, 48 percent are held directly by households, down from 65 percent in 1988, according to Federal Reserve figures. And 40.7 percent of households have mutual funds in tax-exempt accounts.

But only some of these have income over $250,000 a year, and a portion of those people have their money in accounts protected from taxes. Eric Toder, a co-director of the Tax Policy Center, said as a result market prices should have little to do with the taxes paid on gains because prices are largely “being determined by tax-exempt investors and by foreign investors.”

Article source: http://www.nytimes.com/2012/12/03/business/some-economists-doubt-dire-effects-from-tax-increases.html?partner=rss&emc=rss