An April 15th Look at Taxes and the Stock Market

Includes: DIA, QQQ, SPY
by: Daryl Montgomery

Tax policy can impact not just how much money you pay in taxes, but how much money you are likely to make in the first place if you are an investor. U.S. capital gains taxes have risen and fallen over the last one hundred years and the stock market usually follows the direction of rates. A significant rate increase will be taking place on January 1, 2011.

The reason capital gains are taxed at different rates than ordinary income is that investing involves risk, and capital will not flow unless risk is adequately rewarded. Lower capital gains tax rates encourage more business formation and expansion and brings more capital into the stock market. This is the source of real economic growth. Taking on risk to obtain gain of course means the possibility of loss as well. Uncle Sam is more than willing to demand his share of your profits if you make money, but is no longer your full partner when you experience losses. If you make a million dollars investing, you pay taxes on that million dollars. If you don't have trader status with the IRS and lose a million dollars, you get a $3000 deduction per year and will certainly be dead long before you use it up.

Originally, capital gains were taxed at the rate of ordinary income between 1913 and 1922. Top marginal rates were only 7% at first, but rose to as high as 77% in 1918 to pay for World War I. An alternative capital gains rate of 12.5% for assets held at least two years was introduced in 1922. The top marginal tax rate on earned income was lowered to 25% in 1925. It was an era of low inflation and even deflation starting in the late 1920s. The stock market and economy did quite well; at least for seven years after the lower capital gains rate was introduced.

In 1932, when Herbert Hoover was still president, the top marginal tax rate on earned income was raised to 63%. In 1934, capital gains tax rates were changed and based on how long an investment was kept. For assets held 1,2, 5 and 10 years, the exclusions were 20, 40, 60, and 70 percent respectively. In 1942, top marginal tax rates were increased to 88%, but maximum capital gains rates were capped at 25% for assets held for six months or longer. Top marginal rates went as high as 94% in 1944 and 1945. They remained at 91% or 92% until 1963. The huge differential between marginal rates on earned income and capital gains rates along with low inflation created an economic and stock market boom that lasted from 1942 until the late 1960s.

The top marginal rate was lowered to 77% in 1964 and then 70% in 1965. Capital gain rates were raised in 1969. Inflation began picking up at around the same time and the combination was a negative for the economy and stock market for over a decade. The government made the problem worse by raising capital gains rates significantly in 1976 and added insult to injury by taxing gains that only existed because of inflation. Maximum capital gains rates peaked at just under 40% in 1977 and 1978.

In 1978, congress voted to reduce maximum capital gains to 28%. In 1981, capital gains were lowered to 20% and the top marginal tax rate to 50% starting in the 1982 tax year. The high rates of inflation from the 1970s were beginning to decline significantly. An almost 20-year boom period followed. There were bumps along the way, however. The 1986 Tax Reform Act increased capital gains rates to 28% and lowered the top marginal rate on earned income to 38.5% starting in 1987. The marginal rate was lowered further to 28% in 1988. Ironically, equalization of earned income tax rates and capital gains, a long sought goal of certain liberal economists, took place during the Reagan administration. The U.S. stock market zoomed for the first eight months. Unfortunately, it then fell almost 40% in a few days in October.

Marginal rates started rising in 1991 and reached 39.6% by 1993. The Taxpayer Relief Act of 1997 reduced maximum capital gains rates to 20%, once again creating a significant differential between earned income rates and capital gains. Inflation was falling and low during this time and this kept the real capital gains rate close to the official one. The stock market and economy did extremely well for the next three years until the tech bubble burst. To pick up the flagging economy and stock market, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced maximum capitals gains rates to 15% and made this the rate for qualified dividends as well. Inflation was very low during this period. The market and economy did well for the next four years.

Now the maximum capitals gain rate is scheduled to increase from 15% to 20% after the end of the year. Additional taxes will be imposed later on because of the recently passed health care legislation. It looks like we are entering a period of rising inflation and this will make the actual capital gains rate continually go up. I will leave it to the reader to decide what impact this will have on the U.S. economy and the stock market going forward.

Disclosure: Long oil.