Tax expectations may speed stock sales

The tax man, in search of revenue, cometh to Wall Street.

With investors expecting the U.S. government to take a bigger chunk of stock-related profits no matter who wins the White House in November, the investment mantra, "buy low, sell high" may soon give way to "buy low and sell before taxes on capital gains and dividends rise."

That potential urge to sell before tax rates go up could act as a fresh headwind for stocks, which are already struggling under the weight of a slowing economy, depressed housing market and upheaval in credit markets.

"The deck appears to be stacked against investors on the tax front," notes Dan Clifton, head of policy research at Strategas Research Partners. Higher taxes on investments, he says, could result in lower stock prices and less demand for stocks as folks seek out more tax-friendly assets, such as municipal bonds.

An analysis by Strategas suggests that stocks will have a more difficult time moving higher in the face of rising tax burdens. In general, higher taxes make stock investing less profitable.

If the current 15% tax rate on both capital gains and dividends, which has been in force since President Bush pushed them through in 2003, are made permanent beyond the 2010 expiration date, the estimated fair value of the Standard & Poor's 500-stock index would be 1523, nearly 9% higher than Friday's close of 1398, says Strategas. In contrast, if Democrat Barack Obama wins and boosts the capital gains tax rate to 28% and dividends to pre-Bush levels of 39.6%, the fair value dips to 1375, or 1.6% below the market's current level.

There's a growing consensus on Wall Street that the next president will be so shackled by a massive budget deficit and campaign promises that the ability to cut taxes, or make current investor-friendly tax rates permanent, will be limited.

"Regardless of who wins, the probability is in 2009 or 2010, tax rates are going up," says Adrian Cronje of Wilmington Trust Wealth Advisory Services.

Republican nominee John McCain may find it difficult to make the Bush tax cuts permanent, because the Democrat-controlled Congress will likely let them expire without a vote.

Similarly, Strategas predicts a major tax bill, with increases in capital gains, dividends and income taxes, as early as next summer if Obama becomes president. "Proposed tax cuts will never be followed up on," Clifton predicts. Taxes are likely to go up across the board if Hillary Clinton wins, given her push to reform health care at a cost of $100 billion, Clifton adds.

Even though stocks rose in the 1990s despite tax increases from then-president Bill Clinton, that's unlikely to happen this time because consumers are under so much pressure, Cronje says.

Linda Duessel, equity strategist at Federated Investors, says higher taxes won't necessarily cause a sharp slide in stock prices, which are not currently overvalued, but could limit the market's upside.