As the “fiscal cliff” approaches, investors are beginning to freak out about the impact of higher taxes on stock market returns. This particularly concerns the impact of capital gains and dividend taxes which are scheduled to surge at the end of the year if Congress doesn’t act.
“A resolution to the so-called “fiscal cliff” is anyone’s guess at the moment, but what is clear based on our client conversations is that the prospect of higher taxes has clearly spooked investors,” writes BMO Capital Markets’ Brian Belski. “In fact, the S&P 500 has shed close to 5% since Election Day.”
However, Belski argues that the “influence of tax policies on stock prices is inconsequential.”
“We believe the business cycle determines stock market direction, not taxes,” he writes. “Fortunately, we have seen some tailwinds in important parts of the economy lately that are likely to persist unless our government does the unthinkable and allows us to go over the fiscal cliff – which we view as a low probability outcome.”
Belski looked at how the markets performed following major tax hikes:
…over the past 100 years taxes have been increased just 17 times and just seven times during the post WWII period. … According to our work, average market returns are quite strong in the years immediately following tax hikes. For instance, the S&P 500 has returned roughly 18% during the first year of a tax hike, on average, and was able to maintain high levels of return for up to five years following the initial tax hike (Chart 2). By contrast, market performance has been well below historical norms in the years immediately following tax cuts. Again, this is because the economy happened to be weaker in those years, not because of tax policy.
Here’s the chart from Belski’s note to clients:
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