Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Capital Gains and the Candidates

Friday, September 4, 2015


Alan Reynolds’ piece in the Wall Street Journal (September 2, 2015) reminded us of recent internal discussions regarding the link between Presidential campaigns, tax proposals and equity prices. These deliberations centered on the degree to which recent market turmoil could be attributed to talk of substantial increases in capital gains tax rates.

Ativo has long believed that the interaction between inflation and taxes strongly influences the real cost of equity capital and therefore stock prices. Briefly, stock prices reflect investor expectations of a relatively stable real after-tax return. The cost of capital adjusts to offset the effect of inflation and taxes, thus the underlying after-tax rate remains stable. Higher tax rates or higher inflation translate into a higher cost of capital, which depresses stock prices.

To shed some light on the tax rate topic, we performed a simple sensitivity analysis, using our internal assumptions. We found that increasing the capital gains tax rates by ten percentage points (e.g., from 20% to 30%) raises the real cost of equity capital by 50 basis points, which depresses stock prices by approximately 5%. This quick calculation doesn’t incorporate any second order effects, such as the degree to which tax policy and equity prices influence overall economic activity or business investment.

There is far too much uncertainty at this stage of the game to formulate credible probabilities on the various specific scenarios. However, if tax rates do ultimately change, we believe it is safe to say that there will be some impact on stock prices. Depending on the degree of change in the tax rates and specific types of holdings to which the various tax rates might be applied, the impact could be substantial. As for specifics, we will leave it to political junkies out there to put bets on Presidential candidates and their favored tax rates. As a form of entertainment, it’s cheaper than a night at the movies.