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Higher taxes threaten stock rally

By Alexandra Twin, senior writer

NEW YORK (CNNMoney.com) -- Between the new Medicare tax on investment income and a rise in capital gains and dividend taxes, investors will face higher costs. But the overall effect on stock returns is not as cut and dry.

"It's hard to quantify the impact when stimulus, global expansion and so many other factors also drive growth," said Kelli Hill, portfolio manager at Ashfield Capital Partners.

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By 2013, investment taxes for the wealthiest Americans will rise to roughly 24% from the current level of 15% -- the highest level since the Reagan era. The tax applies to roughly 1 million individuals who earn over $200,000 and 4 million couples who rake in more than $250,000.

While this group makes up just 2% of the population, it's a far bigger driver of market activity than the other 98%. In addition, the higher rates aren't tied to inflation, meaning middle-class Americans will eventually price into the group.

On the plus side, the tax hikes are spread out over several years and are just one of many factors that influence stock values, suggesting the impact on the broad market will be moderate.

In fact, markets have been known to thrive in a higher investment tax rate environment. From 1986 until 1997, when the top capital gains tax rate was at 28%, the Dow gained in all but one year, with average returns of 15%.

But this time around, the psychological impact may play a bigger role. With the U.S. economy still reeling in the aftermath of the worst recession since the 1930s, investors have more reason to show caution in the near term.

"You'll probably see more of a sideways pattern in the stock market over the next few years, but it's a little muddy as to how the higher taxes might factor in," said Linda Duessel, equity market strategist at Federated Investors.

Bracing for the tax hikes

With some of the 2003 tax cuts expiring at the end of this year, wealthy Americans will likely see a boost in long-term capital gains taxes to 20% from 15%. Starting in 2013, they'll also pay additional Medicare taxes - an extra 0.9% of their wage income and an extra 3.8% on investment income.

Duessel said that the government was giving investors time to first absorb the end of the Bush tax cuts before the Medicare tax kicks in, which should ease the blow. Additionally, tax policy could change after the mid-term elections.

The taxes would hit those whose gross income, which comprises earnings plus investments, tops $200,000 for individuals and $250,000 for couples. Investment income, also known as unearned income, refers to capital gains, dividends, interest, annuities and rent, among other things.

"Anytime you raise taxes, you provide some incentive to sell the underlying stocks, but I don't think these will have a big impact," said Douglas Elliott, fellow at the Brookings Institute and a former investment banker at JPMorgan Chase.

He said that's partly because the tax impacts all types of investments, including both stocks and bonds, so it doesn't make one more advantageous over the other from a tax perspective.

"I think there will be some psychological impact, just like there was when capital gains tax rates came down (in 2003), but that was a short-term impact," Elliott said. "Longer term, stock returns are still driven by fundamentals."

In 2003, investors shifted assets into big caps and high dividend paying stocks after President Bush lowered the capital gains taxes.

Following that logic, Duessel said higher taxes should theoretically hurt the higher dividend paying stocks because high-income investors tend to bail out of those areas and move into tax-free areas like municipal bonds when capital gains taxes go up. Dividends have historically accounted for nearly 40% of investors' total returns.

However, the pressure on dividend-paying blue chips could be contained this time since those stocks haven't kept up with the pace of the rally that boosted the S&P 500 73% off 12-year lows hit in March of 2009.

Frontier Communications (FTR) pays one of the largest dividends in the S&P 500 index, yielding 13.4%. Its stock price is up 38% from the March 2009 lows. Dow component AT&T (T, Fortune 500) is another of the S&P 500's biggest dividend payers, with a yield of 6.5%. But the stock price has risen just 18% off the March lows.

While tax-free municipal bonds may offer more competitive yields than cash or Treasurys, they also provide greater risks that come with lending to hard-hit city and state agencies.

Tax hikes crimp savings

Some analysts are more concerned about the impact of higher taxes on savings and corporate profits.

For many investors, the rally over the last 12 months only served to cut or erase the losses they racked up in 2008's bloodletting. Having only just recovered some or all of their holdings, investors may see the threat of higher taxes as a catalyst to bail, said Ken Grant, partner at Waterstone Private Wealth Management.

"If you're thinking of selling and you know you're going to see a tax of 20% in 2011 and 15% in 2010, you're going to sell ahead of the higher rate that's coming," Grant said.

But for investors with a longer-term focus, ditching stock holdings for tax reasons doesn't make a lot of sense when bonds, cash and cash equivalents offer little in the way of competitive yields, he said.

The higher tax rates are more likely to impact individual stocks, as investors demand higher price-to-earnings valuations now that their after-tax rate of return will be lower. This could put pressure on companies that are already expecting to take charges related to other requirements of the new law.

But the higher taxes are not likely to change market participants' broad investing habits or dramatically impact the way they value companies, said Ashfield Capital's Hill. "From a long-term perspective, it slows investment growth, but it doesn't cut overall investing."  To top of page

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