There is no question that the falling stock market is both an indicator of a weakening economy and a cause of it. Although the principal cause is an excessively tight monetary policy, there are also many laws, regulations and other government policies helping to push the market down.
Last year at this time, a number of analysts warned that the stock market was in for a dip as mutual fund investors were forced to sell shares in order to raise cash to pay their taxes. This problem is still with us, but now has been joined by a related one. Many workers who exercised stock options last year now find themselves owing substantial taxes on options that actually have fallen in value. They, too, must sell shares to raise cash for taxes. This suggests that any rebound in the stock market is at least several weeks away, until after April 15.
The problem for mutual fund investors is this: Fund managers buy and sell stocks, often realizing taxable capital gains that are attributable to fund shareholders, even when they have not sold any of their fund shares. Thus, even when the overall value of one's mutual fund has fallen, managers may still have realized considerable gains on stocks bought in previous years. The only way a fund owner can cancel these paper gains and avoid a tax liability is by selling his shares at a loss and using that loss to offset the gains.
Many employees with incentive stock options essentially have the same problem. They exercised their options early last year, before the stock market plunge, thus creating large paper gains. Now, of course, many of these options are worth only a fraction of their value a year ago. Like the mutual fund investors, these workers must pay taxes on gains from which they received no cash. Many sold their stock last year, realizing their losses in order to avoid having taxable gains, which helped push the market downward. Those that did not, hoping for a market rebound, find that they must sell now to raise cash to satisfy a tax on nonexistent profits.
To see how this works, consider the case of Frank Han, a co-founder of eToys.com, as recounted in The Industry Standard. Early last year, he exercised 250,000 stock options he had acquired for between 1 cent and 14 cents. At the time, eToys was selling for almost $20 per share. By year end, the price was down to just 25 cents, still enough to give Mr. Han a gain. Even though he didn't sell his shares, the Alternative Minimum tax still gave him a tax liability of about $1 million.
Then Mr. Han discovered that as a company "insider," he was prohibited by Securities and Exchange Commission regulations from selling his shares and taking the loss, which would have eliminated his AMT bill. It turned out that the only way he could do that was by leaving the company. So Mr. Han was forced to leave a company he helped found simply because of a crazy law that would have forced him to pay taxes on gains he never saw.
An added problem for some of those with stock options is that the law is so complicated, many are only now discovering their tax liability. But they have missed the opportunity to soften the blow by realizing their losses, because that would have had to been done before the end of last year. This means that they must sell even more shares than otherwise in order to raise cash to pay the IRS.
Taxes don't just force investors to sell when they don't want to. They can also inhibit people from selling, which can also have a negative effect on stocks. This results from the fact that investors must hold an asset for at least 12 months to get the long-term capital gains rate of 20 percent. Consequently, even when an investor knows that a stock he owns is going to fall, he may be reluctant to sell because he does not want to be taxed at rates up to 39.6 percent on short-term gains. This inhibits liquidity and makes it harder for investors to protect themselves from market downturns. The capital gains tax also encourages year end selling of stocks that have already fallen in price, because investors need the tax losses to offset their gains.
Government regulations are also a factor in the market's slide. One is an IRS requirement that affects foreign investors, which became effective on Jan. 1. Known as the Final Withholding Regulations, they require foreign financial institutions to provide the IRS with extensive information about foreign investors in the United States. Richard Rahn, former chief economist for the U.S. Chamber of Commerce, says these regulations "have caused a massive withdrawal of foreign investment into the United States over the last few months, further depressing our stock markets."
Obviously, anything that discourages foreigners from investing in U.S. stocks is going to have a very adverse effect on prices. In recent years, foreign capital inflows have been an important factor bidding up stock prices. Now, this capital is flowing instead to markets in London, Paris and elsewhere instead of New York.
Another regulation is a recent one affecting the disclosure of financial information. Companies used to be able to provide guidance for reporters about factors affecting earnings in order to ease the impact when financial reports were officially released. This was deemed to be unfair, so the SEC now requires that all material information be disclosed simultaneously to everyone. While well intentioned, the net result has been to reduce disclosure and force bad news to come out all at once, rather than a little at a time, thus contributing to price volatility.
One could go on and on. Other areas of concern would include antitrust policy, which punishes success, and out-of-control trial lawyers, who often go after successful companies not because they are really guilty of anything, but just because they have "deep pockets." George W. Bush should appoint a task force to look into these and other ways government policy might be improved to remove unnecessary burdens on a struggling stock market.