Gains-Tax Cut Would Hardly Sting Today’s Stock Market

The last two times Congress cut the capital-gains tax rate, the stock market declined sharply as investors sold shares to take profits at the new, lower tax rate.

So would the capital-gains cut from 28% to 20%, which now seems likely, be the only thing that could stop the raging bull market?

Possibly, investment experts say, but it would be a small and short-lived dip because the times, the structure of investments and the investment psychology have changed.

In 1978, when the capital-gains rate was cut from 35% to 28%, the Dow Jones industrial average dropped 11% in 12 days, according to stock market historian Yale Hirsch. There were other factors then too. Interest rates were heading toward double digits, oil prices were high and the United States generally was in the middle of a dreadful economic period.

In 1981, when the rate was cut to 20%, the market lost about 15% over 12 months. The country was still coming out of the 1979-81 hyperinflation, interest rates were high and a recession had taken hold.

Clearly, economic conditions are better now, but what else has changed? Three things, basically: the explosion in stock mutual-fund ownership; the creation of widely used tax-advantaged retirement accounts such as 401(k)s and IRAs, on which investors pay no capital-gains taxes when they trade; and the public’s tendency in recent years to buy every time the market drops, which has put a floor under declines.

Stock mutual funds now have about $2 trillion in holdings, including money held in retirement accounts, according to the Investment Company Institute. And Access Research, a Windsor, Conn., service that tracks retirement money, says that 401(k) accounts alone hold about $500 billion in equities, either in mutual funds or employer stock.

“When you have a large part of the market driven by retirement accounts, a capital-gains cut doesn’t mean anything to them,” said Robert Froelich, chief investment strategist for Zurich/Kemper Funds in Chicago.

Still, some dropoff is expected. David Blitzer, chief economist for Standard & Poor’s Corp., estimates a 5% drop.

“If the Fed then raised the interest rate, the market would get killed,” Blitzer said. “But if they did nothing or cut the rate, the market will go up and no one will notice.”

Most investment professionals consider the capital-gains cut proposed by Congress to be a small one. For example, if you invested $10,000 in 1995 in Vanguard’s 500 Index Portfolio, the value of your investment has about doubled, to $20,000. If you sold now, you’d pay $2,800 on the $10,000 gain under current law. If the cut proposed by Congress goes through, your liability would be $2,000, a savings of $800.

“It is generally better not to make a decision based solely on taxes,” said Stephen Canter, chief investment officer of Dreyfus Corp.

“It is better for the investor to take the long-term perspective that a capital-gains tax cut is good for the overall improvement in the economy. But there will be some upper-income investors who would want to unlock some of their gains.”

Are there reasons to sell if there is a gains cut?

“Why would you incur a 20% tax rate if you haven’t arrived at your goals unless you need the money right then?” asked Joseph Clinard, a principal in North Shore Capital, a brokerage and financial planning firm in Melville, N.Y. “Why would I start selling just because the tax rate is more favorable? I will have less to reinvest.”

Perhaps a major reason to sell then would be to rebalance your portfolio, said New York financial planner Joel Isaacson. For example, you planned to have 65% of your money in equities but the market boom has pushed that allocation to 80%. You could sell some shares, take the 20% capital-gains hit and reinvest the proceeds in another asset class like bonds.

But consider looking at your total portfolio.

“People often tend to compartmentalize their investments,” said Don Phillips, president of Morningstar Inc., a Chicago mutual fund ratings and research service. “They think, ‘This is my retirement money. This is my investments,’ and don’t put them together.”

What investors need to do is look at everything they own before making a decision, Isaacson said, because there are other ways of rebalancing a portfolio without incurring taxes. The first, though maybe not the easiest, is to add new money to an asset class (bonds, for example) until it reaches the level you want. That’s fine if you have new money.

The other way is to sell stocks or stock funds in your retirement accounts in order to diversify overall.