Get Us the President

Story Highlights:

• The Bush tax cuts expire December 31, 2010, and investors worry the possible demise of 2003's capital gains tax breaks would usher in a dry spell for markets.
• But historically no such pattern appears. Other fundamentals can overwhelm impacts from a tax rate move. And in the global economy, US tax rate moves don't matter as much as you think.
• Considered counterintuitively, a capital gains tax can be a tax on selling. If you raise taxes on something, you get less of it and vice versa.
• A tax hike is no sure thing and 2010 is still a ways away. It's too early to hit the panic button, and history says there's no need to anyway.

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With the 2008 presidential election in full swing, taxes are a hot topic these days. And they should be: As inevitable as paying taxes, it's just as customary to see your dollars "well spent" on 10 public workers and an abacus for every fully-automated private sector spreadsheet.

Reminds us of a recent trip to the DMV when, after a forty-five minute wait, we dutifully presented our registration, birth certificate, passport, multiple utility bills, and uprooted mailbox with the day's contents undisturbed. The surly "service" employee briefly glanced at our paperwork then intoned this eight-syllable edict of doom: "We can't help you. Your street's not zoned." Not zoned!! What does that even mean? Who's in charge of this zoning? Can we talk to them? Get us the president.

Unfortunately, inefficiencies aside, you'll likely always pay taxes. The question is how much? The Bush tax cuts expire December 31, 2010, and investors worry the possible demise of 2003's capital gains tax breaks (a minimum hike from the current 15% to perhaps 20%) would usher in a dry spell for markets.

By Tom Herman, The Wall Street Journal

Before rushing to conclusions, we like to consult old man History. What happened to markets the last four times capital gains taxes were changed (1981, 1987, 1997, and 2003)?

• In 1981, the rate was cut from 28% to 20%. The S&P 500 declined by -22% over the next 12 months.
• In 1987, the rate was hiked from 20% back to 28%. The S&P 500 rose by +39% over the next eight months.
• In 1997, the rate was cut from 28% back to 20%. The S&P 500 continued its bull market ascent well into 1998.
• In 2003, the rate was cut from 20% to 15%. The S&P 500 began a five-year bull market run.*

Conventional wisdom says lower investment taxes boost prices by making stocks more attractive and vice versa. But there doesn't appear to be any such pattern here. What's going on?

Remember, taxes are just one consideration when buying or selling stocks—other fundamentals can overwhelm impacts from a tax rate move. And we live in a global economy, where US tax rate moves don't matter as much as you think.

Or consider this counterintuitively—a capital gains tax can be a tax on selling. If you raise taxes on something, you get less of it and vice versa. Less selling can lead to higher prices, more selling to lower. History gives us no compelling reason to expect great market returns after a tax cut or poor returns after a hike.

Also, despite all the worry, don't forget higher capital gains aren't locked in yet. Obama could still lose the election, or the Democrats may use the Bush tax cuts as a bargaining chip (they're still politicians after all!). This strategy would simply be a twist in the now-yearly ritual extending of the Alternative Minimum Tax (AMT) patch. Most Democrats would like to do away with AMT altogether, but the Republicans keep them dancing with one-year patches. We could see the same thing happening in reverse with the Bush tax cuts.

2010 is still a ways away. It's too early to hit the panic button, and history says there's no need to anyway. You can probably put off installing an emergency line to the president—unless of course you plan to fight that zoning thing all the way up the chain of command!

* Source: Thomson Datastream