For Many Investors, Cut in Capital Gains a Nonevent

Here’s what was predicted to happen in the wake of last year’s sharp cut in the capital gains tax rate:

* Many investors who were sitting on hefty long-term gains in stocks were supposed to begin selling heavily.

* Investors who were trading-oriented were supposed to be encouraged to lengthen their typical holding period for securities.

* Smaller stocks were supposed to become more attractive than bigger stocks, and bonds--already viewed as far less attractive than stocks--were expected to become even less desirable.

Well?

Six months after the tax rate cut, there is no evidence that individual investors have been aggressively taking profits in stocks; there is some evidence that more individuals are lengthening their holding periods; smaller stocks still are lagging big stocks (for the fifth year in a row); and bonds have blossomed in popularity.

Overall, for the majority of individual investors the capital gains tax cut has been a nonevent in terms of shaping behavior, many financial advisors say.

Maybe it’s early. Or maybe the capital gains tax’s impact on investors’ decision-making process is far less significant than the tax’s detractors would have us believe.

The most feared potential consequence of the tax cut--the unleashing of pent-up selling pressures, now that Uncle Sam is taking a maximum of just 20% of every dollar in long-term gains, down from a maximum of 28% before--obviously was a no-show.

The tax cut took effect July 28. The Dow Jones industrial average hit a record high Aug. 6, and the Nasdaq composite index of mostly smaller stocks hit a record Oct. 9. Any profit-taking was modest until Asia’s turmoil finally gave some investors a reason to sell, triggering the Dow’s 554-point dive Oct. 27.

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There was precedent for worrying that the tax cut would, in fact, prompt heavy selling. The last big reduction in the capital gains rate, in 1981, appeared to immediately spur investors to exit stocks, and for an extended period.

But those were the days of double-digit interest rates, when any excuse to sell stocks was a good excuse.

Also in that era, relatively few investors held stocks in tax-deferred accounts such as individual retirement accounts and 401(k) plans. Today those accounts are many investors’ primary investment vehicles. Changes in the capital gains rate are irrelevant for those investors, because any money pulled from those accounts is taxed at ordinary federal income tax rates (up to 39.6%), not at the lower capital gains rate.

(For institutional investors such as pension funds, taxes are never a concern because they are tax-exempt.)

Perhaps most important, in the eighth year of the great 1990s bull market, many investors simply aren’t interested in dumping stocks, period, because belief in the market’s long-term appeal is as strong as it has ever been.

“I didn’t have anything I wanted to sell,” said 71-year-old Marv Davis, a San Fernando Valley investor, when asked whether the gains tax cut affected his behavior. If he takes profits in stocks he has held for several years, such as Lucent Technologies and SBC Communications, Davis said, “what else am I going to do with that money?”

For as long as investors can remember, “selling anything has been a mistake, strategically,” said Arnold Kaufman, editor of Standard & Poor’s Outlook investment newsletter in New York. That mentality easily overrides any temptation to sell just because Uncle Sam’s hand now doesn’t reach so deeply into investors’ pockets when they take profits.

The government also gave some investors a good excuse to hold tight, of course, by lengthening the holding period to qualify for long-term capital gains tax treatment, from 12 months to 18 months.

“I’ve had a lot of people say they’re putting sales of [assets] on hold to wait out the 18 months” and thus qualify for the lower tax rate, said Gale Reid, financial planner at American Express Financial Advantage in Glendale.

Still, so long as investors feel that stocks’ bull market has further to run, Reid believes that their natural inclination is to hold on indefinitely. “I haven’t had any clients with substantial stock portfolios come in and say, ‘Let’s sell because it’s cheaper now’ ” from a tax-bite perspective, Reid said.

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The disinterest in profit-taking, if indeed widespread, would run counter to what Congress was told when the capital gains tax was cut--which was that the reduction would boost the Treasury’s tax revenues in the first few years after enactment.

The congressional joint committee on taxation estimated that an additional $6.37 billion in capital gains taxes would be collected in the current fiscal year, for example.

“Am I surprised that certain things have not happened? Not really,” insisted Mark Bloomfield, president of the American Council for Capital Formation in Washington, which fought hard for the gains tax cut.

Although investors may have good reason for holding appreciated securities now, Bloomfield argues that in the long run, people will feel freer to make investment changes with the capital gains tax lowered.

“I would still argue that there will be more mobility of capital”--a key goal of the council, Bloomfield said, because the economy’s dynamism should depend in large part on the ability of money to flow to its highest and best uses.

For now, however, one segment of the stock market that had expected to benefit from the lower capital gains rate is still waiting.

While in theory the tax cut should encourage investors to gravitate toward smaller stocks, whose long-term returns are almost exclusively in the form of capital gains--rather than dividends or interest payments--look at the trend since July: Smaller stocks rallied sharply in August and September, but since October they have again taken a back seat to dividend-paying blue-chip stocks.

That has also been the pattern for most of the last four years.

Whatever smaller stocks’ increased appeal from a tax standpoint, concerns about their liquidity have been keeping some investors away, given the market’s rising volatility over the last six months.

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Meanwhile, bond mutual funds have in recent months been more popular with individual investors than at any time since 1993, even though bond interest earnings are fully taxable.

Bonds’ renewed appeal, while the stock market is hitting new highs, suggests that more investors are choosing not to exit stocks, but rather to buy bonds as a hedge for their stock portfolios.

As for the tax consequences--well, it may hurt to pay ordinary income tax rates on interest earnings, but either bond buyers figure it’s worth the price to have a hedge, or they haven’t focused much on taxes, period.

Financial advisors say they sense more of the latter than the former with their clients.

Tax rate changes may ultimately affect every investor, “but I don’t think most people make their investment decisions” with taxes in mind, said Brent Kessel, a Santa Monica financial planner.

When it comes to picking mutual funds, for example, “more often a client will ask which funds have five-star ratings from Morningstar,” the fund-rating service, rather than ask about tax implications, Kessel said.

That isn’t necessarily a bad thing. Taxes loom large at this time of year, but in the long run most investors are much better advised to remain focused on maintaining the proper mix of investments, and investing regularly, than on wasting too much time trying to outsmart the tax man.

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Tom Petruno can be reached at tom.petruno@latimes.com