President Obama's 2013 budget includes a provision to raise the capital gains tax to the regular personal income tax rate which for the highest earning tax payers will be 39.6% next year. Add to that the 3.8% ObamaCare surtax and phase out of deductions of 1.4% and you have a top tax rate of 44.8%, far above the current flat 15% rate on capital gains and dividends today.
As any prudent investor knows, taking into account potential taxes is a very important part of choosing an investment. Decisions like these allow tax-free bond issuers (governments) to pay below-market rates. Taxes also encourage individuals to invest using specially designated tax-advantaged retirement accounts. These special accounts, however, have limits far below the capital invested by any serious investor. Therefore taxes must be paid on significant portions of investments and these taxes can act to deter an investor from committing capital to any given company (causing the company to not have capital to hire new people, so on, and so forth).
Certainly a three-fold rise in the capital gains tax will have an impact on the viability of some investments. To measure the impact I decided to see how the academic 10% desired return would fare in a 44.8% capital gains tax environment compared to the 15% standard set by the previous administration.
Using the hypothetical assumption that Jane Investor has $1 million to invest, seeking a 10% return she'd need $1.1 million after one year to reach her goal. That $100,000 profit would have to be after taxes are deducted. With a 15% tax rate the corporation would need an after-tax profit on her investment of $117,647 or 11.76%, while a 44.8% rate would require a profit of $181,159 or 18.12% to meet the investor's desired 10% after-tax goal. Comparing these returns to the return on equity (ROE) of each component in the Dow Jones Industrial Average (DIA) shows us whether or not an investor would have been successful being part of the investment, or equity portion, of each company's balance sheet under each scenario.
I looked at each company's ROE for the trailing twelve months to see if the rate exceeds either the 11.76% or 18.12% rates corresponding to the 15% capital gains "Bush Rate" and 44.8% proposed "Obama Rate." The results are a series of simple yes-or-no tests determined by whether or not the ROE of a company exceeds the pre-tax required rate of return.
|Company||ROE||Bush Rate||Obama Rate|
|American Express (NYSE:AXP)||27.81%||Yes||Yes|
|Bank of America (NYSE:BAC)||0.63%||No||No|
|General Electric (NYSE:GE)||11.86%||Yes||No|
|Home Depot (NYSE:HD)||20.04%||Yes||Yes|
|Johnson & Johnson (NYSE:JNJ)||16.38%||Yes||No|
|JP Morgan (NYSE:JPM)||10.55%||No||No|
|Procter & Gamble (NYSE:PG)||15.56%||Yes||No|
|United Tech (NYSE:UTX)||23.45%||Yes||Yes|
|Exxon Mobil (NYSE:XOM)||26.81%||Yes||Yes|
In total we end up with 22 companies (73.3%) meeting the 15% capital gains investability standard, but only 15 companies (50.0%) meeting the standard if we assume the proposed 44.8% rate.
Of course this data only reflects the Dow Jones Industrial Average components and not the hundreds of thousands of companies trying to attract capital both publicly and privately. Raising the capital gains tax this drastically has a major impact on investor willingness to commit capital to companies with a potential for profit because it sets the return on equity burden far too high by this measure, thereby eliminating the ability of nearly one quarter of companies to meet a basic rate of return. As a result, without some balancing relief, many companies and investors will look for opportunities outside the United States to help shield them from this tax increase. Further, the flight of capital out of the country will only exacerbate the poor economic conditions in the US, leading to less job creation and little, no, or negative economic growth.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.