We all like having more money in our pockets. Most folks consider lower taxes an obvious benefit to their personal financial situation, and naturally they resist higher taxes. Investors may think that stocks also benefit from lower taxation. After all, it seems logical that lower taxes would positively affect stocks. Paying less in taxes means more money in investors’ pockets—more money to invest. But how much do tax changes really affect stocks? This is a particularly relevant question as we approach the April filing deadline for 2018 taxes. In effect, this is the first year the effects of the 2017 Tax Cuts and Jobs Act will really hit home for many investors. While that legislation only affected some types of taxes, we believe the broader truth applies: most tax shifts don’t have a big impact on stocks.
Historically, there is no correlation between minor tax shifts and stock returns. How does that make sense? After all, taxes take money away, right? They must have some negative impact on stocks! To look at the “why” behind this, first consider how efficiently markets “price in” new information. Stocks’ prices typically reflect the impact of a future change as soon as it is expected, and usually well before it actually takes place. Whether proposed taxes changes affect capital gains, personal income, corporate tax rates or otherwise, the changes are known and discussed at length well in advance. The stock market knows about these changes during proposal, discussion and implementation. If tax changes didn’t impact the market in 2018—and we don’t believe they were a significant driver—then they certainly lack the power to affect markets in 2019.
Even corporate tax changes, which many investors believe directly affect companies and their share prices, often have less of an economic impact than many expect. While many investors projected an outsized economic stimulus from US companies’ repatriation of overseas cash after the tax act, huge multinational companies are sophisticated and have long known how to skirt annoying tax barriers. They navigate capital to where it is most profitable, whether or not they have the cash on hand.
What about capital gains? The 2017 Tax Cuts and Jobs Act did not change the capital gains rates, but the brackets for the different long-term capital gains rates changed slightly. The short-term capital gains rate may also have changed for individuals, as it is dependent on an individual’s ordinary income rate. Regardless of the specific capital gains tax changes, we don’t believe changes drive stocks. Remember that capital gains taxes apply when you sell stocks that have grown—they do not apply when you simply hold a stock that has grown. In fact, if stocks are more expensive to sell, it may even be reasoned that capital gains tax hikes would encourage investors to hold their stocks—thereby reducing selling pressure and potentially moving prices higher.
Following that same line of reasoning, a reduction in capital gains tax rates could be an incentive to sell now. If appreciated stocks are cheaper to sell now, investors could take advantage of the situation lest taxes increase in the future. If investors are all selling to take advantage of lower capital gains taxes, they could put selling pressure on the market, potentially driving stock prices lower.
So which scenario does the evidence support? Do higher capital gains taxes hurt investors by taking money out of their pocket? Or do higher capital gains taxes help investors by reducing selling pressure? Neither. Investors on both sides can argue that it intuitively makes sense that capital gains taxes either hurt or help stock prices, but intuition doesn’t override evidence. Looking historically, it’s indiscernible if capital gains tax changes hurt or helped stocks significantly over the long term.
Consider that in 1981 the capital gains rate was cut significantly—from 28% to 20%. The S&P 500 fell 22% over the 12 months after the law was enacted.[i] Then in 1987, the rates were changed, back up to 28%. The S&P rose significantly, but then dropped in the 1987 crash.[ii] In 1997, the rate was again cut down to 20%. The S&P 500 continued the bull market run it was already in.[iii] Then in 2003, the rate was cut again, down to 15%. Stocks dropped sharply in reaction to the announcement, but when the rate cut was actually enacted, stocks had begun a bull run.[iv]
What do these examples mean? Will tax changes cause the market to drop? Rise? Rise then fall, or fall then rise? These examples show that it is possible for tax change announcements or legislative action to affect the stock market in the short term. But the specific direction and magnitude of those short-term effects are not consistent. And in the long term, it’s clear that you cannot bet on specific market direction based on tax changes. Many factors impact the stock market. There can be concurrent or overriding factors affecting the market at the same time as tax changes.
This all isn’t to say tax policies can’t have an impact on the market. They certainly can! But they aren’t the final decider when considering market drivers.
You might find personal benefit from capital gains tax cuts, or personal income tax cuts. Or maybe you personally support tax hikes. Taxes can have an effect on your income, corporation’s finances, and can have short-term market effects. But don’t let tax changes guide your actions when it comes to your investments. Taxes matter—but not for their predictive power.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: Global Financial Data, Inc., as of 03/13/2019. S&P 500 price return from 08/13/1981 to 08/13/1982.
[ii] Source: Global Financial Data, Inc., as of 03/13/2019. S&P 500 price return from 01/01/1987 to 10/19/1987.
[iii] Source: Global Financial Data, Inc., as of 03/13/2019. S&P 500 price return from 05/07/1997 to 03/24/2000.
[iv] Source: Global Financial Data, Inc., as of 03/13/2019. S&P 500 price return from 01/01/2003 to 05/28/2003.
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