A  43% Tax Rate Coming to Your Neighborhood Soon - Implications for Future Stock and Bond Market Pricing

Last week the Senate Budget Committee passed a fiscal 2011 budget resolution that moves the top tax marginal rate on dividends to 39.6%. That rate applies to taxable incomes over $373,650 ($11,200 for trusts). In other words, dividends will be treated the same as salaries and wages, interest, business profits of proprietors and partners, and all other ordinary income as now defined by the tax code. You may recall that President Obama proposed in his 2011 budget eliminating the "Bush" tax cuts, essentially raising the tax rate on dividends to 20%. In 2001 under President George W. Bush's leadership, Congress passed the Economic Growth, Tax Relief and Reconciliation Act of 2001 which lowered the top tax rate from 39.6 to 33 percent phased in over a number of years. As it happened, the top tax rate never got below 35%.  The 2011 budget resolution seeks merely to reverse those tax cuts.

There are other tax rate increases coming.  Effective in 2013 the healthcare bill includes a 3.8% surcharge on investment income. It also raises the medicare tax on payrolls to 2.35% from 1.45% for families with more than $250,000 of modified adjusted gross income ($200,000 for singles). In 2011 the low income taxpayer will also have to pay the marginal ordinary income tax rates of 10% and 15% on dividends. Those taxpayers who had a zero tax rate in 2008 and 2009 will find themselves with a tax bill in 2010 as the zero rate disappears and ordinary tax rates kick in. All other taxpayers will no longer have the benefit of the 15% rate, starting in 2011. For example, a joint return reaches the 25% bracket at $68,000 of taxable income in 2010 ($34,000 for singles). 

What is Included in Net Investment Income

The definition of net investment income is much broader than people might think. It includes not only interest and dividends, but it also includes royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property. That would seem to include net capital gains on securities, based on an initial reading of the healthcare law, which generally is not entirely clear at this early stage.        

Who Will Pay the Top Rates

According to data furnished by the IRS on the top 400 U.S. individual taxpayers, only 220 of those were in the top marginal tax bracket. The minimum annual income of the top 400 taxpayers was $138.8 million. Eighty-one percent of their income came from capital gains, dividends, and interest. The top 1 percent of all taxpayers composed of approximately 1.4 million taxpayers paid 40.4 percent of  all individual income taxes in 2007. This IRS data shows, along with OECD data, that the US, not France or Sweden, has the most progressive income tax system among OECD nations. This data does not take into account the many more taxpayers who are in the marginal top rates of 28% to 33%. Those folks are far more numerous.

What Was the Effect of Tax Rates on the Markets

Consider one of the findings of a study done in 1988 by David M. Cutler, Department of Economics at Massachusetts Institute of Technology, Cambridge, Massachusetts entitled Tax Reform and the Stock Market: An Asset Price Approach in which he evaluated the effect on the market of changes in the 1986 Tax Reform Act. He found that share volume on the day after the votes of both houses of Congress were about average and the market moves were very minor. While the paper is highly technical and lengthy, Cutler's conclusion was that the hypothesis of large, immediate changes in share values due to the 1986 Tax Act didn't stand up.

Anecdotal evidence is available for the effect of the 2001 Tax Reform Act although suspect. In the six quarters before the 2003 tax cuts, the gross domestic product increased at an annual rate of 1.7%. In the six quarters after the 2003 tax cuts, the gross domestic product increased at an annual rate of 4.1%. What effect the coming out of the recession had, we do not know.

In an article published in January 2007, Brian Riedl concluded that tax revenues correlate with economic growth, not tax rates, pointing out that since 1952 when the highest marginal rate was 92%, the tax revenues have remained in a range of 17% to 20% percent of GDP, regardless of the tax rates. We think that this near perfect correlation suggests  two things: tax rates do not materially affect stock prices (they are affected more by corporate profits in the long-run) and raising tax rates will not significantly raise revenue as a percent of GDP. Taxpayers and their tax advisors almost always find ingenious ways to reduce the impact of rising rates.

What Investment Strategies Could Mitigate Rising Rates

We would advise moderate bets on gold, ETFs, non-dividend paying growth stocks, small cap stocks, and municipal bonds, although there is default risk to munis. An municipals ETF or mutual fund might lower risk. We would avoid large exposures to utilities, REITs, high dividend-paying stocks, and US Treasury bonds and notes. Save some of the high interest, high dividend paying investments for retirement accounts that defer taxes. Diversification is still good policy and we wouldn't completely abandon asset categories that produce lower after-tax returns. As the time draws near to 1/1/2011, there are sure to be other asset categories that will lend themselves to tax-efficient investing.