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The Fiscal Cliff and the Stock Market

3 min readBy: William McBride

Today the president announced he will begin negotiations next week with House leaders regarding the impending fiscal cliff, and that he will continue to insist on higher taxes for high income earners. This means more of the same stale mate that has persisted since 2010. At this point, higher taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rates in less than two months are a near certainty, since they are baked into the law with the expiration of the Bush tax cuts and other provisions. It is just a question of how high they will go.

Democrats appear to have more leverage, since they have stated they are willing to endure the stalemate and go over the fiscal cliff even though by all accounts it would lead to a recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. .

However, another factor is the stock market. The Dow is down about 4 percent since the election, and it dropped about 100 points immediately following the president’s remarks this afternoon. This sort of market action scares politicians of all sorts, and if it continues we can expect significant tax relief.

But will the market continue to dive? Marko Kalonovic of J.P Morgan gives us some idea. In a report issued July 24th he basically predicted the market’s recent decline:

In the second half of 2012 the macro environment likely will continue to be dominated by political risk in developed market countries, with two main sources of political risk: 1) fiscal uncertainly related to US elections in November and 2) handling of European sovereign debt crisis. To gauge the potential impact of US tax regime changes on performance and volatility of the stock market, we have analyzed income, corporate, capital gains, and dividend tax rates and annualized returns of national stock markets for 34 OECD member countries over the past ten years. Our analysis suggests higher tax rates negatively impact national stock market returns and can explain up to ~40% of returns. Statistical analyses imply increased tax rates in hypothetical Democratic Party tax scenario could result in a market decline in 7-15% range, while decreased corporate tax rate in hypothetical Republican Party tax scenario could have a positive market impact in 7-14% range.

By this analysis, the market has further to fall if the president succeeds in negotiating something similar to his preferred outcome. I suspect market action will weigh heavily on next week’s negotiations.

Marko analyzed separately the effect of different types of taxes on market returns and found taxes on corporate income, individual income, and capital gains are all negatively associated with market returns. He found taxes on dividends do not have such an effect, apparently because of the ability of corporations to retain more earnings instead of paying out dividends, and the ability of investors to switch to low-dividend paying stocks. Most pertinently, he found the following effects of the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. :

Individual income tax rate: The income tax rate in OECD countries has shown strong negative correlation with average market returns – the higher the income tax rate, the lower the average stock market return. This relationship suggests that individuals collectively are likely more efficient than governments in allocating resources to the economy. An additional explanation could be that lower income tax rates enable individuals to save and invest directly, thus propping up stock market. The relationship of market returns and high-income tax rates (OECD data for tax rate at 167% of average income) has been the strongest (statistical significance of 2.9, Figure 1). The low-income tax rate (OECD data for tax rate on 67% of average income) has had a weaker but still positive correlation to market returns (statistical significance of 1.8). Progressivity of income tax rate (defined as difference between tax rate at 167% of average income to tax rate at 67% average income) has shown the strongest impact on stock market returns, with an increase of one percentage point in high-income tax rate relative to low-income tax rate corresponding to lower average annual stock market return of ~0.67% (Figure 2).

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