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A Capital Gains Cut Won't Gore Wall Street

Finance: TAXES


Perhaps it's just coincidence: A few weeks after the Republicans' dramatic sweep into power, the stock market starts a rally that carries the Dow Jones industrial average up nearly 900 points without so much as a hiccup. High on the GOP's list of promises is slashing the 28% maximum tax rate on capital gains. How much of the market's climb is attributable to the sweet smell of a tax cut is an open question. After all, lowering the rate raises investors' returns, reduces the cost of capital for corporations, and should create jobs and prosperity.

But already, some market watchers are warning there's a short-term price to pay for such long-term benefits. They argue stocks could tumble when the new tax rate goes into effect, as investors take advantage of the cut to cash in their hefty gains.

POWERFUL PROD. "People who have sizable gains are going to see this as an opportunity to liquefy their portfolios," notes Steven H. Abernathy, director of the private client group at Cowen & Co. Indeed, perhaps one reason the market has gone up for eight months without a correction is that investors are waiting for the tax cut. Says David G. Shulman, stock market strategist at Salomon Brothers Inc.: "Cut capital-gains tax, and you invite people to sell."

Of course, that's the point: to prod investors to move capital from less productive to more productive uses. But even if sellers reinvest their proceeds, they can't reinvest them all: They must set aside some money to pay capital-gains taxes. "Unless you can get 100% of the money back into stocks, the market could fall," says Jeremy J. Siegel, professor of finance at the Wharton School of the University of Pennsylvania, who advocates a cut nonetheless.

In theory, a sell-off sparked by lowering the capital-gains tax makes sense. But in reality, it is not a foregone conclusion. For one thing, a lower capital-gains tax could also attract new dollars to make up for what has been pulled out of the market. Factors such as corporate earnings, interest rates, and the economy are more important--even in the short run--than capital-gains tax.

BUT WHEN? Details won't be worked out until autumn, but the betting is that it will exclude half of any capital gain from taxation and apply the taxpayer's regular income-tax rate to just the other half. So wealthy investors in the 39.6% bracket will see the rate on a capital gain drop from the current 28% to 19.8%. Investors of more modest means who now pay 28% would see the rate drop to 14%. The House of Representatives' bill also calls for indexing capital gains to inflation, so investors will not be taxed on inflation-generated profits. The indexing plan, considered costly and complicated, is less certain to be enacted, but its chief backer is an influential one: Ways & Means Committee Chairman Bill Archer (R-Tex.)

And there's still no certainty about when the lower rate would go into effect. The House bill makes it retroactive to Jan. 1, 1995, but selling a stock today banking that the tax will be at the new low rate is a risky proposition. Most likely, the effective date would be when Congress agrees on the final bill.

Congress has lowered capital-gains taxes three times in the past two decades, and there's little evidence that the cuts had much impact on stock prices in the short term (chart). For instance, in 1978, the top rate fell from 35% to 28% for assets sold after Oct. 31 of that year. But the market plunged before the effective date, so anyone selling had to pay taxes at the old and higher rate. The reason for the "early" sell-off: Inflation was rising rapidly and the Federal Reserve tightened credit and hiked interest rates.

True, stocks tumbled nearly 12% in the three months following the 1981 tax law, when the maximum rate was further reduced to 20%. But you can hardly blame that on investors' cashing in gains. At the time, the economy was in recession, and short-term interest rates were 15%. In such an environment, equities are ugly. The maximum rate went back up in 1987, but stocks have done swimmingly since then, as companies have restructured, trimmed costs, and raised profit margins. Perhaps most important, interest rates have come down.

TAX, SHMAX. Moreover, the structure of the equity market has changed dramatically in the past 15 years. Today, about one-third of the money in the stock market is controlled by investment managers, who have little concern for taxes. Pension funds don't pay taxes on investment earnings, and mutual-fund managers trade as they like and pass the tax liabilities along to shareholders. And even if they control only one-third of the equity, pension-fund and mutual-fund managers account for most of the trading activity.

Some fear that venture capitalists may take a capital-gains cut as an opportunity to cash out and swamp the market with initial public offerings. But venture capitalists dispute that--and note that much of their money comes from tax-exempt investors, too.

Even individual investors who can take advantage of the tax cut may not be in a hurry to cash out. Those saving for such long-term goals as education and retirement may be content to stay put. Why pay any tax if you don't need the money now? Elderly investors have even less incentive: When stock passes to their heirs, it escapes the capital-gains bite altogether.

Pessimists may be right that the market will stumble under the weight of a lighter tax bite. But if so, it's a small price for investors to pay for the long-term benefits that will be unleashed.By Jeffrey M. Laderman in New York, with Russell Mitchell in San Francisco

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