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Boulton: Higher taxes hurt retirement investments

Boulton: Higher taxes hurt retirement investments

April 29, 2009
April 29, 2009

Whether you’re comfortable with the idea or not, is immaterial. The amount of money available to pay your retirement benefits is directly related to how well the stock market performs over the coming years. Historically that has averaged out to roughly 8% to 9% since the founding of the New York Stock Exchange in 1797, but as we all know, there have been some wild swings from year to year with one of the worse coming in 2008 when the Dow Jones Industrial Average plunged over 40% from peak to trough (so far).

Since investing in the stock market is an anticipatory process and collectively most investors are not totally stupid, part of the decline from 1400 in October of 2007 to just over 6000 by February 2009 was due to expectations of what President Obama’s going to do with the capital gains and dividend tax rates. In all likelihood these rates are going to be increased at the expense of higher stock prices to everyone’s detriment.

As I learned over the many years I was a stockbroker, people are very conscious of how realized stock market profits are going to increase their income tax bills – almost to the point where they were willing to see a major ‘paper’ profit turn into a real loss so that they wouldn’t have to pay Uncle Sam and the State of California a single dime. Before President Reagan cut taxes from the then top marginal rate of 81%, many preferred to invest in tax shelters with less than stellar performance than plant their savings in the stock market. When push came to shove, tax sheltered benefits trumped stock market profits.

With this in mind, knowledgeable financial advisors valued individual stocks based on their potential after-tax rates of return. For example, let’s say a stock was bought at $10 per share and then sold at $12 for a $2 profit – a 20% gain, whoopee. Except for the fact that even under President’s Bush and Clinton the top marginal tax rate for investors living in high tax states like California and New York, the income tax rate was 50%, so that the 20% profit was only a net after-tax 10% in reality.

If this stock paid a buck per share in dividends, the dividend yield wouldn’t be 10%. Considering taxes, it would only be 5% since the dividend paid was shared equally with the government. If our investor wanted a 10% annual yield after-taxes, he’d only pay $5 for the stock. Of course this meant that the pre-tax dividend yield would have to be 20%, which is very hard to find with any kind of confidence that the dividend would be paid for more than the past quarter.

Ergo, corporations like Intel and Microsoft never paid any dividends, choosing either to use surplus corporate monies to buy back shares to force their stock prices higher or retained the money for investment in other areas. Finally it came to a point where both companies made almost as much money from their investments as they did from their basic business – effectively, they’d became banks as much as they were technology companies.

This changed when the Republican Congress working with President Bill Clinton cut the tax rate on both dividends and capital gains to 15%. This dramatically increased the after-tax returns for just about all common stocks because the after-tax return from dividends instantly jumped 70% and stock prices rose to reflect this. Now to get a 10% after-tax dividend yield from the aforementioned stock, our investor could pay $8.50 per share, or a 70% increase over want he paid before the tax rate was cut. The same holds true for the numerical exercises we can play with realized stock market profits. Thus cutting these tax rates alone threw fuel on the fire during the bull market of the 1990s and greatly accelerated the rise in stock prices that occurred.

Now the president wants to raise the tax rate on dividends and capital gains to 20% or higher. That represents a tax hike of a third and cuts the after-tax return for our investor who paid $8.50 for his $1 dividend to 8% - ouch, because this cuts the stock price to $8 for a fifty cent per share, or 6.25% drop in value, in order to maintain parity with the prior after-tax dividend yield. Translate this effect over the entire stock market and one can see why the threat that such policies would be imposed has cost stock market investors at least 6% of the value of their retirement savings. The same’s true for pension plans like Idaho’s PERSI that public employees depend upon.

Throw into the equation what Obama hopes to accomplish by letting the Bush tax cuts expire and his proposed increase in taxes for ‘all those making over $250,000’ – the one’s most likely to buy stocks outside of their retirement accounts since they have the highest marginal propensity to save, and it’s clear that Obama’s tax policies will have the ‘unintended’ effect of putting a severe damper on the ability of the stock market to recover its 2008 losses because of the multiplier effect the negative impact Obama’s tax increases create is much more severe than our simplistic example given that stock values reflect decades of stock values out into the future. Unfortunately everyone who will eventually retire is dependent upon a market recovery of substantial proportion, or their ‘golden years’ could easily be one of penury.

Craig Boulton has written a number of books on finance, economics and political economy. He has written for Cato, and is a chartered financial analyst with more than 20 years of experience in the investment industry. He's also a combat veteran.

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