TALKING TAXES

In the US there are 2 broad tools our government uses to intervene in the Economy: Monetary Policy and Fiscal Policy. Fiscal Policy can be divided into Government Spending and Taxes. For Today, as we await the election results, lets talk taxes.

We can also breakdown Taxes into multiple categories: Corporate, Personal, and Capital Gains. Through some basic economic reasoning one can see that, all else equal, a rise in taxes should cool off the economy and the stock market would be expected to react poorly as well. Below is a simplified Aggregate Supply and Aggregate Demand for all goods and services in the US. If the corporate tax rate was raised the supply curve would rise, raising prices and decreasing output. This is the green scenario depicted below. Similarly if personal taxes were raised the demand curve would drop, lowering prices and lowering output. This is the Blue scenario below.

So now that we know what theory says should happen, lets look historically at what has actually happened. We’ll look at tax increases going backwards from present day:

• In 2013 there was an increase to both personal and capital gains tax, the market rallied roughly 30%.

• 1993 saw an increase to all 3 tax groups, the market was up 7%.

• 1991 also saw personal and cap gains tax increases, market rose 26%.

I could keep going but you get the idea. The only year since 1950 where the market had a down year in a year when tax rates increased (capital gains) was in 1969 (11% drop). In fact if you just look at corporate tax increases, the market has risen 100% of the time, in both the year prior and year during the raise.

So what gives? Is economic theory wrong? In this instance, that’s unlikely. However, the theory we looked at simply focused on a situation that could never occur in the real world. It looks at taxes ceteris paribus. “holding all else equal”. The real world does not hold all else equal. There are too many factors that move the market. And in fact, many of them are co-varied with taxes. For example, with increased taxes there is often an increase in government spending as well as monetary policy factors that likely create multiplier effects that push output beyond those of taxation.

While it is important to understand the effects of tax changes on the market it is more important to have the complete picture. Between interest rates, the money supply, government spending, and taxes, all have their effects on the economy and markets. Rarely, if ever, does it make sense to look at only one in a vacuum.