Capital Gains Taxes Set To Rise, Crimping Investment, Savings

Investors Business Daily | By Jed Graham

Bull markets always have to climb a wall of worry. This one also will have to climb a stairway of tax hikes.

Democrats’ health care overhaul (including the still-pending reconciliation bill) nearing the finish line would apply a 3.8% Medicare tax on investment gains earned by upper-income households starting in 2013. Along with a partial expiration of 2003 tax cuts at year-end, rates on long-term capital gains and dividends are due to jump in two steps from 15% to 23.8%.

The big shift in tax policy is one that could raise the barrier to saving and investment in a savings-short economy and make capital harder to come by. Near-term, it also could affect portfolio decisions as investors weigh higher taxes.

“It’s a head wind into which this bull market needs to move,” said Hugh Johnson, chief investment officer at Johnson Illington Advisors.

The 2013 long-term capital gains rate for higher earners would still be below the pre-1997 level of 28%.

The White House wants to tax dividends at the same rate. But if Congress doesn’t act it will more than double at year-end for high-earners.
While stock markets have performed well in periods of higher rates, the increase is one that may trigger some adjustment as investors balance risk and reward.

“I have lots of clients that have said maybe we ought to move our selling plans ahead,” Johnson said.

Those conversations have clearly picked up in recent weeks as the Democrats’ plan to tax investment income to help pay for health care became clear, Johnson said.

Although the looming tax hikes haven’t changed Johnson’s relatively positive outlook for stocks and the economy, they have dampened it a bit.

Don Luskin, chief investment officer at Trend Macrolytics, noted that while changes in capital gains rates are rare, stocks typically move in the opposite direction of tax rates over the following year.

Plan For Tomorrow
Although the 2013 tax hikes are nearly three years from taking effect, Luskin notes that they would impact most meaningful investments under consideration today.

“The chilling effect on the economy will start to be felt immediately,” he said.

In 2013 and beyond, Luskin adds, the high-income threshold for the higher rates — $200,000 for singles and $250,000 for couples — will become more of a middle-class problem because it isn’t adjusted for inflation.

Economists generally agree that higher investment tax rates increase the cost of capital for businesses as investors require higher pre-tax returns to offset taxes.

Still, some argue that a big gap between investment and income tax rates is inefficient because it leads to tax-avoidance strategies.

Yet Mark Bloomfield, president of the American Council for Capital Formation, said raising taxes on productivity-enhancing savings and investment is the opposite of what should be done to foster a strong economy.

“The long-term strength of an economy is its long-term level of savings and investment,” Bloomfield said. “We have got a shortage of savings.”

The higher tax rates will incrementally shift incentives away from savings and investment to consumption, he said. If Washington wants to tax the rich, he said, it should tax their consumption.

“Tax their yachts and their Cape Cod estates,” he said.

Bloomfield also sees higher investment tax rates working against families trying to rebuild their nest eggs after the financial crisis and recession.

For households looking to grow their investment savings, what matters is “how much capital is available,” he said.

Don’t Hold Your Breath
Just how much of the looming increase in investment taxes has been priced into the markets is impossible to know, Luskin said.

Investors might even be holding out hope that the Medicare tax increase on investment might be rolled back if Republicans retake the House in November, he said.

But even with a GOP House, getting a rollback through the Senate and past President Obama is unlikely short of major tax reform. Instead, with deficits expected to stay at unsustainable levels, there may be pressure for further tax hikes.