March 27th, 2017 | by

Changing Tax Regimes and Your Stock Portfolio

  • With talk of tax cuts coming from Washington, many investors are pondering the implications of lower taxes for their equity investments.
  • Looking at long-term trends in tax rates (personal income and capital gains, specifically) and equity market performance, at first blush it appears that falling taxes coincide with rising stock prices.
  • However, a closer examination of the data reveals that multiple factors have influenced equity market returns under various administrations, and in fact, the stock market has risen or fallen pretty much independently of specific tax legislation.
  • In virtually any tax regime, investors would be well served by ensuring that their personal tax considerations are incorporated into their overall investment strategy.

Like clockwork, with a new President, come new proposals for dramatic changes in the tax code. Presidents George H.W. Bush, Bill Clinton, and Barack Obama raised income tax rates; Ronald Reagan and George W. Bush cut them dramatically. Although no legislation has yet been signed into law, both President Trump and the Republican-controlled Congress are proposing sharp tax cuts. For example, the Trump and House GOP proposals both call for a reduction in top marginal personal income tax rates from 40% to 33% and a repeal of the 3.8% net investment income tax tied to the Affordable Care Act. The House plan also effectively calls for lower taxes on capital gains, interest, and dividends.

Can we predict the effect on stock market performance of tax cuts of this magnitude? We’re well aware that debate on taxation can quickly become politically charged, with conservatives typically arguing for lower taxation and liberals tending to support higher tax rates, at least for those in the highest income brackets. As keen students of behavioral finance, we at Gerstein Fisher also recognize that political biases and emotions can easily cloud peoples’ investment decisions (see /viewpoints/hillary-donald-better-portfolio/). With that context, and since we try to avoid conducting numberless conversations, we decided to look back in history to explore any strong links between changes in tax rates and subsequent stock market performance.

Falling Taxes, Rising Markets

We first examined some long-term trends. As Exhibit 1 depicts, the top federal income tax rate peaked at 94% in 1944-1945 during World War II, steadily declined and was slashed from 70% to 28% during the Reagan Administration. Then the rate increased again to 40% on the watches of Bush Senior and Bill Clinton, before being cut again to 35% by Bush Junior, and then returned to 40% by President Obama.


Exhibit 2 illustrates a similar but less volatile story with capital gains tax rates. These peaked at 40% in 1976-1978, were cut to 28% during the Carter Administration and lowered to just 15% under G.W. Bush, before Obama boosted the top capital gains tax rate to 20%.


At a macro level, the long-term trendlines appear to indicate a negative correlation between declining tax rates (on personal income and capital gains) and the historical performance of the S&P 500 Index, which returned 10.04% annualized from January 1926 to December 2016. But let’s keep in mind that during this 91-year time frame many long-term economic trends were also at work, including demographic shifts, innovation, productivity gains, inflation, interest rates, and globalization.

The Search for Patterns

Therefore, we decided to examine the shorter-term link (one year)–more of a cause-and-effect relationship– between personal income tax rate changes and S&P 500 Index returns from 1936-2016. Exhibit 3 reports the years of tax-rate changes and the associated market responses for the same years. One can find cases when tax hikes coincided with market declines, such as in 1941, when Franklin Roosevelt was President and the world was at war; or when tax cuts appear to usher in a bull market, such as under Reagan in 1982.


But Exhibit 3 also shows several periods in which tax increases coincided with dramatic stock gains (as during the Clinton and Obama administrations), and some in which cuts were accompanied by stock losses (2001-2002). We measured the statistical correlation between tax rate changes and US stock market annual returns from 1936 to 2016 and found it to be 0.14, which is extremely low. In other words, historically the stock market has risen or fallen pretty much independently of specific tax legislation.

There are clearly multiple factors at work (including luck and randomness) that could influence stock prices during any particular Presidency, year, and tax regime. As one example, Bill Clinton hiked personal income taxes by a dramatic 30% to the 40% level, while maintaining the capital gains tax rate at a relatively steep 29%. Yet the stock market boomed during his Presidency, with the S&P 500 Index returning 17.20% annualized from January 1993 to December 2000, enough to turn a $10,000 investment into $35,600 during eight years. There may be several credible explanations for the Clinton bull market (I’ll cite one possibility shortly), but it’s hard to imagine that substantial tax increases are among them.

Instead, let’s just consider one important economic variable that coincided with Clinton’s tenure in office: a jump in productivity growth. In his magisterial book, The Rise and Fall of American Growth, Robert Gordon notes that from 1994-2004 there was a temporary surge in annual growth in total factor productivity (“TFP:” a measure of expansion of economic output that is not explained by growth in labor and capital inputs) that was nearly double the growth rate of TFP from 1970-1994 and 2.5 times the rate of TFP growth in the economy since 2004. Professor Gordon argues that the jump in productivity was largely an outgrowth of innovation, inventions, and, specifically, the rapid decline in the cost of computer speed and memory (trends which pre-dated the Clinton Administration), which helped to trigger a one-off surge in investment in information and communications technologies. Thus, quite possibly the productivity story was a far more important explanation than tax changes for the outsized stock gains.

In closing, I should note that we are not saying that tax changes are not important to investors and to the overall economy. Quite the contrary: at Gerstein Fisher we believe that adroit tax management is a vital but often overlooked strategy for successful long-term investment performance (see, for example, /viewpoints/art-science-investing-presence-taxes/). Rather– despite what media pundits afflicted with linear thinking and/or harboring political agendas may assert–we are merely noting that our research demonstrates a very weak correlation in the past in terms of the short-term impact of tax changes on the performance of public equity markets.





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