The spending reductions and tax hikes brought about by the “fiscal cliff” are likely to impact the stock market in several important ways. Prudent investors should take note of the possible ways in which their individual portfolios might be affected.
1. Higher dividend rates will hurt both middle and upper class income earners.
Currently, dividends are taxed at an average 15% rate. After the fiscal cliff, dividends will be taxed as ordinary income — meaning at rates up to 39.6%. How does this affect after tax yield on a stock? Consider GE, with a dividend of $0.76 per share, or a dividend yield of 3.7%. Currently, the after-tax dividend rate is approximately $0.646. After the fiscal cliff, this rate could be as low as $0.46 per share. This represents a stunning 29% drop in after tax dividend income!
2. Because of the increase in dividend tax rates, the value of dividend paying securities could decline under substantial selling pressure.
Some investors who rely on dividend payments for income may be forced to sell holdings to compensate for loss of after-tax income. Furthermore, investors may reallocate capital from some dividends paying securities to other investments which possess greater potential for capital growth.
3. The top long term capital gains rate is also set to increase as a result of the fiscal cliff, jumping to 20% from 15%.
Although some middle class investors may avoid this top tax rate, all will feel the effects in another very important manner. Most investors, and most definitely sophisticated one, have a required expected rate of return on investments. This expected rate of return takes into account the risk of the investment and the taxes on expected gains.
Startups, technology firms, and pharmaceutical companies in particular require significant amounts of initial capital. Although the failure rate of these companies is often much higher than established companies, the possibility of large capital appreciation attracts investors despite the higher risk. An increase in the capital gains tax rate diminishes the expected return of these riskier ventures, guaranteeing that the “required rate of return” threshold for some investors will no longer be met and deterring capital investment in these companies. Equity values in these types of companies will likely decline. This harms investors, the companies which fail to attract capital, and the broader economy as fewer successful businesses come to fruition.
4. The payroll tax holiday is set to expire on January 1.
This will result in a 2% decrease in take home pay for most workers. Consumer cyclical stocks are likely to be temporarily impacted by this decline in discretionary income. This negative impact, however, should not be an excuse for politicians to continue funding social security expenditures with borrowing rather than the payroll tax.
5. The spending sequestration portion of the fiscal cliff will result in a 9% “cut” to defense spending in 2013.
Companies that derive a large source of their revenue from government defense contracts, such as Lockheed-Martin and Boeing, will likely experience significant selling pressure as the military is forced to reduce expenditures, particularly on military hardware.
6. The marginal tax rates of all income tax brackets are set to increase as a result of the fiscal cliff.
Although certain politicians wax eloquent about the need for the “rich” to “pay their fair share,” this rhetoric neglects an important fact. As the government siphons off yet more money from the private sector, less capital remains in the hands of those who earned it to invest. The initial result of this may be diminished inflows into the broader capital markets, which will provide downward pressure on the value of securities.
The longer term consequence of higher income taxation is less capital accumulation, negatively impacting the ability of our nation to increase the means of production. Both investors and non-investors alike should be concerned about this.
In summary, the fiscal cliff will impact the stock market by reducing the after-tax value of dividends, generating selling pressure on dividend-paying stocks, diminishing the expected after-tax rate of return on a myriad of investments, hampering consumer spending, shrinking revenues at defense-oriented firms, deterring capital investment, and limiting capital accumulation.