As anxious investors assess their portfolios in light of expected tax
increases on investment income, hedge fund manager Douglas Kass has a
simple message: Relax.
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 S&P 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.”
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