Many pundits and investors have been forecasting big trouble for the stock market if the U.S. goes off the “fiscal cliff” at the end of the year, and tax rates jump on income, capital gains, and dividends. But the firm of top strategist James O’Shaughnessy says history tells another story.
Looking at data going back to 1926, O’Shaughnessy Asset Management looked at how the stock market has fared during times of varying tax levels. “Our analysis suggests that, across history, tax rates and changes to those rates generally have not meaningfully impacted equity returns,” write Travis Fairchild and Patrick O’Shaughnessy in a paper detailing the study. “Surprisingly, dividend-paying stocks performed best when taxes were highest.”
OSAM separated all years from 1926-2011 into three categories — high, middle, low — based on the average effective tax rate for a family earning $250,000. It found that in the 1/3 of years with the lowest effective tax rate, the S&P 500 gained just 3.7% annualized, and produced an average dividend yield of 3.7%. In the third of years with the highest tax rate, the index gained 11.3% annualized, with a yield of 4.5%. In the middle third of years, it gained 13.9%, and yielded 3.3%.
The group also looked at how the market performed during the 10 years when taxes increased the most from the prior year, and the 10 years when taxes decreased the most. On average, in the year after the 10 highest increases were made, stocks gained 8.4%. The average three-year annualized return was 7.9%, while the average five-year annualized return was 15.7%. Following the largest decreases, one-year returns averaged 13.0%; three-year annualized returns were 8.4%; and five-year annualized returns averaged 13.4%. “Put simply,” Fairchild and O’Shaughnessy wrote, “large tax increases or decreases have not foretold doom or boom for equity returns.”
OSAM found a similar situation with dividends. The outperformance of high-dividend stocks was basically the same, on average, during periods when dividends were taxed as regular income, periods when dividends were exempt from taxation, and periods when dividends were taxed at 15%. They found just one example of a dividend tax increase in the neighborhood of what the fiscal cliff could cause (1954-55), and found that high-dividend stocks outperformed following that increase as well.
Fairchild and O’Shaughnessy say they aren’t arguing that large tax hikes are good for stocks, or that there is a causal relationship between high taxes and strong dividend stock returns. “But it does contradict the projections of those calling for a sell off in dividend-paying stocks as the fiscal cliff nears,” they say, adding that they think valuation declines in high-dividend stocks “should be short-term and unsustainable” and would likely lead to a big buying opportunity. They say now is not a time to panic, and that what should drive stock returns in the future is the quality of companies and the price of their shares — not tax rates.