Conventional economic theory suggests a correlative relationship between tax rates and market performance
by Gregg S. Fisher Mr. Fisher, CFA is Chief Investment Officer of Gerstein Fisher. He is responsible for the management and oversight of the firm’s investment process, including portfolio management, trading, research, risk control, and investment strategy development. Visit gersteinfisher.com. Reprinted with permission.
As Ben Franklin quipped, “In this world, nothing can be said to be certain, except death and taxes.” In the US political system, changes in tax rates almost rise to that lofty level of certainty.
Consider the amount of zig-zagging on tax policies during the administrations of the past five Presidents: Ronald Reagan slashed the top personal income tax rate from 50% to 28%; George H.W. Bush, after famously saying, “Read my lips: no new taxes”…raised the income tax rate; Bill Clinton hiked the personal income tax rate but lowered capital gains taxes; George W. Bush lowered both income and capital gains taxes; and Barack Obama has raised both rates.
Sure enough, as the campaign for the 2016 Presidential election heats up, candidates from both parties are proposing changes to the tax code. For instance, Hillary Clinton has proposed a dramatic increase in capital gains taxes to 39.6% (from 20%) for investments held less than two years. Donald Trump proposes lowering income tax rates and says he supports the Bush tax cuts.
But just how important are changes in tax rates to stock market performance? After all, impassioned debate over tax reform policies in America is as old as the 1787 Constitutional Convention. We did some historical research to study how sensitive the market is to changes in the tax code, which is the subject of this article.
Broad disagreement on tax policy
Conservatives and liberals, not surprisingly, disagree about tax policy, with liberals tending to argue that higher taxation will help the economy flourish, and conservatives maintaining that lower taxes are the key to prosperity. The stock market is an important yardstick by which to measure economic strength, and conventional economic theory suggests a correlative relationship between tax rates and market performance.
For example, household expenditure is dependent upon income levels, so presumably an increase in income due to a tax cut will increase expenditure, and vice-versa. As we move into the thick of election season, we can expect political bloggers and pundits to have a field day with the premise that an increase in tax rates will lower stock market returns by squeezing stockholders’ ability to invest.
Tax Rates Through History
Let’s look first at some long-term trends. As seen in Exhibit 1, since peaking at 94% during World War II, the top federal income tax rate declined steadily and quite dramatically before rising again somewhat in recent years. Exhibit 2 depicts a similar but less dramatic long-term trend in capital gains tax rates.
The long trend lines seem to indicate a negative correlation between falling personal income and capital gains tax rates on the one hand and S&P 500 Index historical price performance on the other. But bear in mind that there are also many macro, long-term economic trends at work here, such as GDP growth, fiscal health, demographic shifts, debt, unemployment, human capital, technology, trade flows, currency, inflation, interest rates, and so forth.
Taxes and the Market
Now let’s drill down and examine carefully the shorter-term relationship (one year) going back to 1936 between changes in personal income tax rates and performance of the S&P 500 Index, which strikes me as more of a cause-and-effect relationship.
Surely, there are some isolated time periods in which tax increases and market declines coincide (such as in 1941, when a few other things were also going on in the world), and when tax cuts appeared to augur a bull market (e.g., the 2003 Bush tax cuts).
But there are also times of tax increases accompanied by dramatic market gains (2013, for instance) and significant tax cuts with no discernible effect on stock prices (as in 1987). In fact, what the data suggest is that in the near-term there is virtually no consistent relationship between tax rates and market performance. When we statistically measured this relationship we found it be 0.14, which is an extremely low correlation. In other words, the stock market has flourished and floundered essentially independent of any specific tax legislation throughout modern history.
We should note that tax changes rarely come as a surprise to the markets, which tend to react to news and information and price them in, thus making the actual tax change itself almost a non-event for the markets. Research by academics such as Nobel laureate Eugene Fama has tended to corroborate this.*
Before closing, I would like to shift gears for a second and stress what I am not saying in this article—that taxes do not matter to investors. Far from it: I believe that tax management is a critical but often overlooked aspect of successful long-term investing.
For that reason, Gerstein Fisher has done considerable research and thinking on the subject of investing in the presence of taxes, and I invite interested readers to read our articles (for example, “The Art and Science of Investing in the Presence of Taxes“) and watch our videos (such as “Tax Management“) on this critical topic.
In other words, I urge investors to focus on important issues over which they have some control (such as incorporating tax management strategies into their investing) and not to get distracted by issues over which they exert no control (such as proposed increases or decreases in tax rates), except to exercise their right to vote at the polls.
Changes in tax rates have been a constant through American history but are fresh on investors’ minds now as the 2016 Presidential race heats up. But our research shows that, though there may be a long-term correlation, there is actually a very weak correlation in terms of the short-term effect of tax changes on the performance of public equity markets.
Investors would be wise to focus more on what they can control—systematically integrating tax management into their investment strategies.