News & Our Thinking

The looming fiscal cliff is a big problem for all Americans, but stock market investors have a reason to be especially concerned.

If Congress does nothing to change current law, the tax rate on dividends and capital gains will jump on Jan. 1. That will make stocks less attractive and could drive prices lower.

How far would values fall, and how quickly would the adjustment happen? It’s impossible to say, for a couple of reasons.

For one thing, this tax increase is no surprise. It’s been the law of the land since late 2010, when Congress passed a two-year extension of many expiring tax breaks. Investors can hope for another extension, but they  know they might not get one.

Ken Crawford, managing director at Argent Capital Management in Clayton, thinks stock prices already reflect the likelihood of higher taxes.

“We’re at record low interest rates, and yet the market is not frothy. That tells me there is a fair amount of suspicion and concern priced into stocks today,” he said.

The other complication is that the increase doesn’t affect all investors. “In Finance 101 we would say the effect depends on who the marginal investor is,” explains Michael Alderson, professor of finance at St. Louis University. “Obviously pension funds don’t care what the tax rate is, and neither do people who are buying stocks for their 401(k) plan.”

So it’s hard to say how hard the tax change will be on the stock market. But since researchers found a positive effect in 2003, when dividend and capital gains rates were cut to 15 percent, it’s reasonable to expect a negative effect now.

“I believe the answer is yes, this does have some effect on stock prices,” says Donald Marron, director of the Tax Policy Center in Washington.

The tax increase will be steep for wealthy individuals. The highest effective rates will go to 25 percent on capital gains and nearly 45 percent on dividends.

(Officially, the capital gains rate rises to 20 percent and dividends will be taxed as ordinary income, with a top rate of 39.6 percent. In addition, the Affordable Care Act imposed a new 3.8 percent tax on investment income, and the Tax Policy Center says the phaseout of certain deductions adds 1.2 percent to top earners’ effective rate.)

In the waning months of 2012, those wealthy investors may do a lot of selling to lock in this year’s lower rates.

“We don’t know exactly what’s going to happen, but if we can accelerate income into 2012 as opposed to future years, that’s a good thing,” said David Walther, director of wealth management services at Purk Advisors in Richmond Heights.

Walther said one of his firm’s clients recently decided to sell some shares and realize a large capital gain, but plans to buy the same companies back because he still likes them.

A move like that shouldn’t have much effect on prices, but other sellers may decide to reduce their exposure to stocks.

Companies that pay high dividends, like utilities, could go out of favor. Some investors have been buying them as an alternative to bonds, enticed in part by the favorable tax treatment.

“This could be a negative, especially for the yield-rich stocks, which I think are relatively expensive,” Crawford says.

Investors should expect volatility, and maybe even a stock market selloff, as the year-end deadline approaches, but shouldn’t overreact.

“I’m not changing any asset allocations or long-term strategies in anticipation of what might happen,” Walther says.