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The tax effect behind the market selloff

After last year’s low volatility and impressive gains, stock market investors have been whipsawed in early 2014. Stocks dropped sharply in January, with the Dow Jones Industrial Average tumbling more than 5%, and falling again Monday.

Yet the roller-coaster ride may just be getting started. Aside from the trouble in emerging markets and slowdown in U.S. manufacturing activity, there is a tax effect at play in the current market downturn, and it is likely to increase market volatility for the rest of this year.

In late 2012, investors sold huge amounts of investments with long-term capital gains to take advantage of the expiring 15% ” Bush ” long-term capital-gains tax rate before the current 23.8% rate for higher-income investors took effect on Jan. 1, 2013. These sales left investors with few unrealized long-term gains going into 2013.

Instead, as the market surged, investors’ new gains were held mostly in short-term positions, which they were loath to sell given that short-term gains are taxed at ordinary income-tax rates (39.6% for high earners). With this inhibition there was less sales pressure last year, and for that reason the market may have risen more than it would have otherwise. Indeed, last year’s 30% market gain exceeded most analysts’ predictions.

This year may be different, with more stocks purchased in 2013 reaching a one-year holding period. With the gains now taxable at lower, long-term rates, investors will be less inhibited about selling when they get nervous. That’s what happened last month. The result? A rush to sell and the Dow’s worst January since 2009. These sales may have been fueled by stock purchased 12 months ago with the proceeds of the huge volume of last-minute sales in December 2012.

There is scant data to confirm this. The Internal Revenue Service hasn’t even published detailed 2012 tax data, which won’t be available until March, much less data for 2013.

But there is one real-time data set that provides very rough guidance. Daily and monthly statements from the U.S. Treasury track individual income-tax receipts, broken down into taxes “withheld,” i.e., paid by employers from salaries and wages of employees and “other”—consisting primarily of estimated payments by self-employed individuals but also taxes on nonwage income from all individual taxpayers, predominantly investment income.

The “other” line spikes in the four months when estimated payments are due, especially in April, when both the first estimated payments for the current year and final payments for the prior year are due. For example, in April 2013 “other” receipts were huge—$209 billion out of a total of $448 billion in calendar 2013. The comparable figures for calendar 2012 were $146 billion out of a total of $351 billion. The $63 billion leap from April 2012 to April 2013 reflects the huge volume of long-term gains taken at year-end 2012 on which taxes were paid with final returns filed on April 15, 2013.

In the three other months, “other” receipts follow recurring patterns. January figures reflect estimated tax receipts for four months and thus exceed September and June figures, which reflect receipts for only three and two months’ income, respectively.

In 2013, January’s “other” receipts were $62 billion versus $50 billion in 2012.

This January’s “other” receipts were $72 billion. While seemingly in line with the 2012-13 trend, the number may actually reflect a lower level of gains-taking. Since fewer long-term gains were available in 2013, it is likely that more gains taken were short-term, which produce roughly twice the tax revenue as long-term gains of the same amount. Fewer gains produced more tax receipts. So in turn we can surmise that there were a greater amount of unrealized gains going into 2014.

A substantial portion of those gains achieved long-term status in early January and may be fueling the current selloff. As 2014 progresses and more unrealized gains mature into tax-advantaged long-term status, investors will be more likely to sell if nervous, and they will be able to sell in greater volumes. In other words, the 2014 market is likely to be more volatile than the 2013 market partly because of the lingering effects of the 13-month-old capital-gains tax-rate increase.

Tax changes can have unforeseen impact far longer than anticipated, including in this case fueling, at least in part, last year’s overdone market advance and the current downturn.

As appeared in The Wall Street Journal on Feb. 3, 2014.


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