With all the chatter in the financial media about the impending fiscal cliff, investors cannot be blamed for their confusion. Some investors have expressed a concern that an increase in tax rates may result in a substantial drop in stock market values or lower expected future returns. Since we are all about data at Index Funds Advisors, we naturally decided to test the hypothesis that stock market returns vary inversely with either marginal or capital gains tax rates. As the two charts below show, neither marginal nor capital gains tax rates have any explanatory power of equity returns. Both of them explain less than 1% of historical returns over the last 61 years. It is interesting to note that some of the highest returns occurred during years when the top marginal rate was 91%! The mean return of each tax era also showed no dependency on that era’s tax rates. Note that the dividend tax rate was the same as the marginal tax rate until 2003 when qualified dividends were introduced.
Explaining a clear-cut relationship between two variables is often easier than explaining the absence of one. In the case of tax rates and equity returns, the former can be viewed as a measure of how much of the latter investors get to keep or spend. Also, a substantial percentage of equity market investments are either tax-deferred or tax-exempt, and these participants would have no basis for changing their views on market prices in the face of tax rate changes.
IFA reminds investors to focus on the aspects of investing that they can control such as how much risk to take, minimizing expenses, and taking advantage of asset location. Regarding tax rates and market returns, investors should simply remember Doris Day singing, “Que Sera Sera (Whatever Will Be Will Be)”.