The day after President Obama was re-elected back into the White House for a second term, the stock market tanked, with the Dow Jones Industrial Average
(INDEXDJX:.DJI) sliding 3.36%, its worst single-day performance of the year.
The index has recovered somewhat since then, though it continues to hover around the 13,000 mark.
The reason for the post-election shareholder malaise seems obvious: With the looming fiscal cliff yet to be resolved, investors are fearful of the prospect of higher taxes come 2013, and are unloading their stock holdings, which, as the New York Times
notes, has hurt the share prices of big names such as Apple
(NASDAQ:AAPL) and Amazon
“There’re multiple pockets of fear. One is that under an Obama administration, it’s more likely we’ll see higher tax rates for high income individuals, since that was part of his platform. There’s some concern about that and what exactly that means, how high those tax increases are going to go, and what sources they will come from -- is it going to be just the income tax, or other increases attached to other legislation?” explained David Twibell, president of Denver-based investment advisory firm, Custom Portfolio Group, to Minyanville.
“There’s also some angst out there, just in our client base and people I’ve talked to, about the overall gridlock in DC and in particular, how it relates to the fiscal cliff. It’s political suicide for everybody to do nothing in the face of the fiscal cliff, yet we’ve got the status quo. [That’s] maybe the reason why there’s so much angst among people I’ve talked to,” Twibell continued.
The big fear is that the capital gains tax rate will increase from its current 15%. “We’ve been proactively, if it makes sense from an investment standpoint, selling some positions with long-term capital gains to try and take advantage of that 15% [tax rate]," Twibell mentioned.
For instance, John Moorin, the founder of a medical equipment company near Indianapolis, told the Times
that he let go of some $650,000 in dividend-yielding equities such as McDonald’s
(NYSE:MCD) and Coca-Cola
(NYSE:KO) because of a fear of a hike in the tax on dividends.
Some conservatives and business advocates have argued that an increase in the capital gains tax rate will paradoxically hurt tax revenues, because investors will pull their money out of equities and into tax-exempt investments such as municipal bonds.
“I can tell you, just in communication right now I’ve had with clients and colleagues, that there’s going to be a massive shift, in my opinion, among business owners and investors to try and take as much advantage of qualified plans and tax-deferred vehicles as possible. And that’s natural. If taxes are going to go up, then people have a choice – they can either be as creative as they can in trying to legally shelter as much income from taxation as possible, or they can pay higher taxes – and it’s human nature for people to want to pay as little taxes as they can,” Twibell said.
“It’s always the law of diminishing returns there – the higher the tax rates go, the more creative people get. Somebody who might have a 401K plan might put a profit-sharing plan on top of it; somebody might look to put a cash balance plan in place. So whatever the [White House] projections are, I doubt they’re going to be fulfilled because high income individuals will probably take some action to take full advantage of tax-deferred opportunities,” he opined.
One investor who does not fear the possibility of higher taxes is Ed Greenberg, founder and president of Los Angeles-based public relations firm, Edge Communications
A supporter of the president, Greenberg tells Minyanville that he makes his investment decisions on factors other than tax avoidance.
“You don’t want to pay any more taxes than necessary, but that’s not a motivating strategy. The motivating strategy on a micro- and macroeconomic level is, in my case and age now, to generate some income from investments,” shares Greenberg. “There are so many other things that enter into an investment decision. If you look at a corporate bond versus a muni bond, you say, ok, the return is lower on the muni, but you’re getting tax relief, so it’s equivalent.” he elaborated.
“I may not be in that bracket where taxes are such a burden that I have to do anything extraordinary to change my behavior – some people are concerned about estate and capital gains taxes – but my view is that the country needs to raise revenue and the best way to do it is for people who can afford it to pay their fair share. It’s a civic responsibility,” explains Greenberg on how he sees the tax situation.
Greenberg highlights the example of his home state, California, where voters passed Proposition 30, which aims to resolve the state’s budget deficit by raising taxes fractionally on higher-income residents. Conservatives have claimed that Prop 30 would drive millionaires out of California, but Greenberg points out that a recent Stanford study
found that the last big tax hike in 2005 did not result in an increase in out-migration of people with incomes over $1 million. He added that he believed that tax rates do affect economic behavior, but that they had yet to reach levels where they would do so.
Twibell also points out that there is uncertainty regarding transferring money into tax-exempt municipals. “One of the things that hasn’t been discussed very much is that under the president’s tax proposal, there would be a cap on the ability of high-income individuals to take advantage of tax-free interest on municipal bonds. The number floats, but it’s somewhere around 28%. [Municipals] are not necessarily the best places to be going right now until that issue gets resolved,” explained Twibell.
Regardless of the effectiveness of moving from stocks to municipals in escaping taxes, would such a change in investment strategy, if implemented by a large number of investors, hurt the economy? Twibell said that there is no definitive answer.
“Just shifting from a corporate bond to a municipal bond really doesn’t have a huge impact on the economy; it probably drives financing costs up a little bit for corporations, but [it also] considerably reduces them for municipalities,” said Twibell, who also offers a hypothetical scenario.
“Let’s say you run a business and you’re making a certain amount of income and your taxes are going to go up. So rather than making that income and maybe reinvesting it back into your business, you take that money and you put it into a 401K plan. That’s money that might otherwise go into consumption or your business or pay bonuses for employees.
“That income now goes into mutual funds that invest in corporations – well, there are some benefits to that. That’s not in itself a negative. But it does potentially reduce the growth of your business or income available to your employees. So there is a consequence to that. It is not all bad, but you could argue that we need both investment and spending and economic growth. But right now, we probably need more economic growth than we need money going into the stock market. I think that’s when the tradeoff comes in,” Twibell said.
Because of the cloud of uncertainty still swarming around the issue of the fiscal cliff, Mag Black-Scott, chief executive of Beverly Hills Wealth Management, advised investors against making hasty decisions. “Any time you make a decision purely for tax reasons, it has a way of coming back and biting you,” she said, according to the Times
“Could you be at a 43% tax on dividends instead of 15%? The straight answer is yes, of course you could. But what if that doesn’t happen? What if they increase just slightly?” she pointed out.
For him to tell his clients that it is safe to invest in equities, Twibell said he needs to see the White House and Congress quickly work out a deal on tax hikes and spending cuts so that there is clarity.
“Let’s say the capital gains tax rate went from 15% to 16% -- that’s very unlikely, but let’s just say it did. That’s pretty minimal and shouldn’t drive investment decisions. But the capital gains tax rate going from 15% to 25% probably does. So even if tax rates go up, I can see a scenario where we might advise clients not to worry too much about tax hikes. But that’s the problem when you don’t have clarity: You assume the worst,” explained Twibell.
“With the lack of certainty, I think we’ve got to err on the side of caution and for [my firm], that’d be to continue to advise our clients to do all the things possible to try to reduce their taxable income for next year.”