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Pepperdine University School of Law

Monday, December 3, 2012

NY Times: Some Analysts Doubt Dire Predictions on Tax Increase Fallout

New York Times:  Some Analysts Doubt Dire Predictions on Tax Increase Fallout:

As anxious investors assess their portfolios in light of expected tax increases on investment income, hedge fund manager Douglas Kass has a simple message: Relax.

Mr. Kass, the founder of Seabreeze Partners Management, thinks much of the investing world has overestimated how hard the markets and investors would be hit if tax rates on dividends and capital gains rise at the end of the year, as the White House has proposed.

Mr. Kass can look for support to several economists who have studied past changes in tax rates and found that the shifts had less of an impact on investor behavior than was initially expected. That’s largely because a dwindling number of investors are subject to the taxes on investment gains that are set to rise at the end of the year, with most stocks held in accounts that are exempt from taxes.

(Hat Tip: Ann Murphy.)

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If Mr. Kass is not willing to make up for costs associated with his advice, at least to his clients, he should simply shut the hell up.

Posted by: Darth Chocolate | Dec 3, 2012 3:47:31 AM

I am in agreement with Mr. Kass's prediction that changes in U.S. tax rates on capital income will have only minor effects on stock prices. Two things must be true for U.S. tax rates to have any effect on prices: (1) investor behavior must be rate-elastic, and (2) enough investors must be subject to the relevant rate change to affect demand for stocks in the aggregate. I'm not persuaded that either is true.

For investor demand for U.S. stocks to be rate-elastic, either (1) there must be alternative investments available to them that are not subject to the rate changes, or (2) the rate changes must cause them to consume more. I have not seen any investment sector advertising that it's a better place to be because it is not subject to the proposed rate changes; the closest is the shift from dividend-paying stocks to growth stocks, but this shift is unlikely to have any impact on aggregate investment in the stock market. And I am profoundly skeptical of claims that investors will respond by spending all their money. Hasn't happened in the past. The claim that they may is not supported by the data. And there's a lot of data.

Mr. Kass points out that large percentages of U.S. stocks are held by investors who are already tax-exempt, and are therefore not subject to any proposed rate changes. General equilibrium theory suggests that these percentages should expand if the proposed rate changes lead to any significant exit from the stock market by taxable investors. In other words, exiting taxable investors should be replaced by tax-exempt investors. Roughly 95% of the world's people are exempt from U.S. taxes on capital income. Some of them have money.

Finally, I would note that it appears that significant numbers of companies are paying dividends and investors are taking their gains in 2012 in anticipation of the changes. This should lead to a significant spike in tax revenues in 2012 and reduction in behavioral effects in later years. Stated another way, it may be that the markets have already internalized the proposed changes.

Posted by: Theodore Seto | Dec 3, 2012 9:52:44 AM