Tax the Rich, Starve the Poor

As the country prepares to elect its 44th president, a great deal of attention is shifting to the economy, a critical component of which is the stock market. The tax policies the next President chooses to implement will have a significant affect on the stock market, and economic growth. Lets explore how.

Broadly speaking, the stock market represents the intersection of:

1. Expected future corporate cash flows

2. The return investors require on their investments, or the equity discount rate

We can think of these factors as “numerator” and “denominator” issues. “Numerator” factors relate to profits and cash flows, and “Denominator” issues, such as tax rates, inflation, and risk relate to the equity discount rate. Because profits and cash flows are commonly measured, the financial press focuses almost exclusively on the numerator side of the market. This is reflected through discussions about the overall economy, and company specific profitability reports. Equity discount rates, in contrast, receive very little media attention, but are equally important to cash flows in determining stock market values. At any point in time, the equity discount rate for a particular company or the market in general consists of 4 components:

A base real rate of return, and additional compensation for inflation, taxes, and risks.

In order to focus on how tax policies affect the equity discount rate, let us assume that equity investors want a 4% base real rate of return and the required compensation for inflation and risk is expected to be 0%. Let us evaluate how the tax policies for the two competing presidential candidates affect the stock market. The Republican Candidate advocates maintaining a 15% tax rate on capital gains and dividends, while the Democrat Candidate advocates moving the rate to 35%. What is the affect of each of these policies on stock market values? First let us determine the equity discount rate under these circumstances.

Equity Discount Rate:

The increase in investor tax rates will increase the equity discount rate by more than 30%. To put this into perspective, let us value a hypothetical company that is expected to generate $100 a year of cash flow into perpetuity. Under these circumstances, the values of this company under the policies of Republican and Democrat Candidates are $2127 and $1613, respectively. (Please note that these calculations did not require a premium for inflation or risk. Incorporating these factors into the discount rate, only serves to increase the final return demanded by investors and further reduce market values and economic growth.)

The higher the taxes on investment returns, the higher the rate of return investors will require for their investments and the less they will pay for a given investment. A natural extension of this concept is that if the tax rate on investment returns increases, the value of those investments in the economy will decrease. In the context of the stock market, moving from lower investment tax rates to higher investment tax rates will lead to a drop in market values, all other things equal.

Unfortunately, that is not the end of the story. As tax rates go up and increase the equity cost of capital, by definition there will be fewer investment opportunities that meet this new, higher required investment rate. As a result, companies, and entrepreneurs will find fewer acceptable investment opportunities. This results in fewer investments throughout the economy and subsequently slower growth. This insight was part of the genius behind the Reagan Revolution, which lowered taxes and freed more capital throughout the economy to empower wealth creation and economic expansion. It is ironic, that by pursuing a “tax the rich” agenda, politicians inadvertently punish the middle class and the poor by reducing the opportunities for the economy to create better jobs and finance new business ideas that serve to economically empower those who need it the most.

So while this may sound good in theory, is there any proof that the markets react to such tax information? After all, markets go up and down every day, allowing anyone to read almost anything they want into such movements in the same manner that Mark Twain said, “figures lie and liars figure”.

But one particular event comes to mind. During the Bush-Kerry election in 2004, each candidate staked out opposite positions on capital gains taxes. President Bush argued that the current 15% rate should be maintained and made permanent, while Senator Kerry advocated raising them on the top 2% of wage earners. An interesting thing happened during that election, as at approximately 2:30 PM EST on November 2nd, flawed polling data leaked to the press indicated that Kerry would win Florida and the entire election. Prior to the false news leaking, the Dow had increased as much as 125 points, or about 1.2% during the day. Afterward the market proceeded to fall 150 points (about 1.5%) from its peak. In other words the prospect of higher taxes immediately motivated investors to sell assets. As clear as the message the market sent about higher taxes was, it sent an even stronger and clearer message about keeping taxes low. Over the next 2 days, the Dow rallied approximately 3% or 280 points signaling its relief that taxes would remain low and capital would likely continue to flow into investments.

America faces a similar choice in 2008. Virtually every Republican has vowed to keep capital gains taxes constant or to reduce them further, while every Democrat has vowed to work to restore capital gains taxes for all (or at least the wealthiest taxpayers) back into the low 30% range. Because polls continue to indicate that no party has a clear path to the White House, the market most likely has not discounted the effect of potential tax changes on stock prices. However, should one side gain a clear advantage, prepare to make appropriate strategic changes in the composition of your portfolio.

Obrycki and Resendes are co-founders of The Applied Finance Group (AFG), a capital market research firm working with over 200 investment houses, corporations, and consultancies around the world. AFG’s clients rely on AFG’s Economic Margin™ research and tools to understand the performance expectations embedded in stock prices. To learn more about AFG’s research, visit www.economicmargin.com.