To the Tax Mobile

Story Highlights:

• The Obama administration has proposed a multitude of tax changes—including a middle class tax cut, raising the two top income tax rates, taxing foreign corporate profits, and boosting the capital gains tax rate.
• Many of the administration's tax plans aren't particularly new or unique—the Clinton administration campaigned on similar tax policies in the early ‘90s.
• Specifically for investors, history shows a rising capital gains tax rate hasn't been plainly bad for stocks, and cuts haven't necessarily been good.
• A period of brisk innovation, productivity gains, or general expectations of better times ahead can overwhelm the cost of higher taxes.

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Taxpayers take heed: April 15th is looming and one mustn't forget one's civic duty. So said one of our nation's greatest citizens:

Batman: "Better put 5 cents in the meter."
Robin: "No policeman's going to give the Batmobile a ticket."
Batman: "This money goes to building better roads. We all must do our part."

To the Tax Mobile! Okay, perhaps the prospect of improved roads doesn't make Tax Day any more appealing. But no matter how you feel about taxes, you're probably aware Washington's been fiercely eyeing some changes lately. Question is, will they help or hurt investors?

Since the 2008 presidential campaign, the Obama administration has promoted a policy of tax cuts for the "middle class" (households making under $250,000), which has thus far included a $10 bump in weekly pay from a "Making Work Pay" tax credit. To help pay for middle class tax cuts, the administration has proposed upping the top two tax brackets, taxing foreign corporate profits (even if they're never brought home), and raising the capital gains tax rate.

Arguably, raising capital gains tax rates impacts everyone who buys stock—including many President Obama would categorize as middle class. And most would agree markets wouldn't enthusiastically greet higher corporate taxes. But Obama's tax proposals aren't something markets haven't grappled with before. Bill Clinton campaigned on middle class tax cuts in his first presidential bid. The rhetoric back then was similar to today's:

Clinton: "We will lower the tax burden on middle class Americans by asking the very wealthy to pay their fair share."

Obama: "I will cut taxes…for 95 percent of all working families, because in an economy like this, the last thing we should do is raise taxes on the middle class."

Similar rhetoric—yet Clinton's first year was perfectly fine for stocks. Of course, investors will be watching the capital gains tax most closely. If we get a hike, would a higher capital gains rate depress markets? Not necessarily. Consider recent capital gains tax rate history:

• In 1981, the rate was cut from 28% to 20%. The S&P 500 declined –22% over the next 12 months.
• In 1987, the rate was hiked from 20% back to 28%. The S&P 500 rose +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.*

In the past 28 years, the capital gains rate has fluctuated between 15% and 28%. Over that period it's been hard to pin down the exact effect of each hike or cut—sometimes markets go up following a hike, sometimes they go down following a cut, or sometimes they just keep on keeping on. Here's why—there's no doubt a higher capital gains rate lowers the net present value of stocks (expected returns less expected costs) and that can lower demand. But higher capital gains taxes can also discourage investors from selling, which can be a positive for prices. And there are other fundamental factors affecting how investors value equities too. A period of brisk innovation, productivity gains, or general expectations of better times ahead can overwhelm costs associated with higher taxes.

We rarely think higher taxes a good thing, but it's key investors weigh all market drivers together—and at the moment, all things considered, other forces may yet prove more powerful.

* Source: Thomson Datastream