Anyone with money in the stock market does not need to be reminded of the blood bath that has occurred since it peaked in March. Almost all are sitting on large capital losses and this is the time of year when they play a paramount role in tax planning. Indeed, there is reason to believe that much of the weakness in the stock market lately was caused by tax selling.
For ordinary investors, the relevant consideration is whether to realize enough of their losses to get some benefit on their taxes. Capital losses are fully deductible against gains, and up to $3,000 of losses can also be deducted from ordinary income. This last can save an investor in the 28 percent tax bracket $840 on his tax return in April.
Mutual fund investors, and those who have received stock options as part of their compensation may have special problems, however. Mutual fund investors may find that fund managers sold stock for a profit earlier in the year, and that such profits give them taxable gains, even though they did not sell any mutual fund shares.
These capital gains distributions to mutual fund investors in effect, force investors to pay taxes on profits they themselves have never actually realized. As a result, they must often sell mutual fund shares to get cash to pay the tax. This tax-driven selling was widely blamed for the drop in the stock market in late March and early April of this year, as investors scrambled to pay tax bills on their 1999 profits.
But in many cases, the mutual funds shares have now fallen sharply, as the stock market itself has fallen. The irony is that mutual fund investors may owe taxes on gains they never saw, while on net they have lost money in the stock market. The only way they can avoid a tax liability under these circumstances is by selling their mutual funds, realizing their losses, and using them to offset the gains that were distributed earlier in the year.
A similar problem confronts those with stock options from their employers. When the market was high earlier in the year, many exercised their options, creating paper capital gains on which they must pay the Alternative Minimum Tax (AMT). And like the mutual fund investors, the only way they can cancel this liability is by selling their stock. Analyst Don Luskin explains how this works:
"Suppose you joined a Silicon Valley technology company a couple of years ago. Let's say it went public last year, and you made a killing on your stock options -- at least on paper. For example, the strike price on your option was $5, and your red-hot company went public at $12.
"The stock traded at $100 in the heady days of February, and you exercised your options to get the clock started for long-term capital gains treatment. Now the stock has fallen back to $25 -- disappointing, but not a tragedy, considering that it cost you only $5 when you exercised your options.
"But here's the rub. When you calculate your tax bill, you may well be subject to the AMT. Under AMT, the difference between the strike price of your options and the stock price at the time of exercise is taxable as ordinary income this year, regardless of the fact that the stock has declined since you exercised.
"That means you are going to be taxed on $95 of income for every share you exercised (the stock price of $100 at the time of exercise minus the option strike price of $5). Even at the lowest AMT rate of 26 percent, you'll owe $24.70 per share -- and your stock is currently worth only
If anyone had difficulty following that explanation, they only need to understand this: there is a lot of selling going on in the stock market solely for tax reasons. If this is the case, then the market could rally in January, once the tax factor is past.
Personally, I believe that most of the weakness in the stock market is due to the Federal Reserve, which has been tightening monetary policy for a year and a half. This tightening has put downward pressure on prices, thereby eroding profits, which has caused stock prices to fall. However, I do not dispute that tax factors are important as well, and may explain the precipitous drop in the market in recent weeks.
Between now and Jan. 20, President-elect George W. Bush must decide what to do with his tax plan. It seems clear that Congress will be unreceptive to swallowing his entire $1.3 trillion plan in one gulp. But there is probably solid support for passage of parts of Bush's tax plan, especially those dealing with the marriage penalty and estate tax relief.
Bush should seriously considering adding a provision to this interim tax cut that would address the problems of capital gains taxes on mutual fund distributions and the AMT. Congressman Jim Saxton, New Jersey Republican, has already introduced legislation to ease the tax bite on mutual funds. And the AMT is a problem that outgoing Ways and Means Committee Chairman Bill Archer (R-TX) has been warning about for years. Thus both issues are ripe for congressional action.
It is probably too late for a traditional tax cut, aimed at pumping up demand, to have any impact on the impending recession. But a supply side tax cut, targeted at investors, might help spark an upturn in the stock market, which would improve the climate for investment and raise consumer confidence. Together with an easier Fed policy, which most economists expect shortly, this would ensure that any recession is brief and mild, and perhaps avoid one altogether.