The war on capital: yours

As our clients are concerned with the creation and preservation of wealth, we thought it might be helpful to present some very basic concepts as to the impact of taxation has on valuation. The linkage is not well understood, so read this, and you'll know more than most Senators.

Let's start with a corporation which, through some stroke of effort and luck, manages to be profitable:

		Corporation
Net Income before tax		$      100.00
Corporate tax @ 35%		$       (35.00)
Net Income after tax		$        65.00
less dividend (30% payout)		$       (19.50)
Add to retained earnings		$        45.50

Out of their $100 in pre tax profits, we assume they pay the corporate tax rate of 35%. We ignore state & foreign taxes for simplicity, which is just as well because you can't figure them without retaining a Wall Street law firm.  We further assume that an individual shareholder receives the dividend and must pay taxes (which we illustrate below at the prospective rates as indicated in today's Wall Street Journal).

		Current	New
Dividend Income		$         19.50	$         19.50
Personal tax
Current	15.0%	$          (2.93)
New	43.4%	$       _______	$         (8.46)
Dividend after tax		$         16.58	$         11.04
% increase in tax			289%
after tax dividend income as % of current			67%

Let's focus: the after tax value of dividends to that individual is now 67% of what it was before.  You used to have a $1.00 of spendable income, you will have 67 cents. 

This will adversely impact every man, woman & child in the United States who plans on retiring; educating their children or themselves; providing for elder care, theirs or others; or simply accumulating enough wealth to buy a small boat or a fiancée a wedding ring ... you may recall the quaint notion in our distant past, the pursuit of happiness?  We see here simply a transfer of wealth, a 'taking' by fiat.

Back to the markets

Most valuation models of equity markets can ultimately be tied to the company's ability to deliver cash to its owners. Gordon's Dividend model defines equity value as a function of the present value of all the dividends the stock pays.

Gordon's model can be stated as

.

where P = the price or value; D = the dividend; k = cost of equity; and g = expected growth rate of D.

We're going to keep it simple. If you are the only shareholder of the whole market (kind of like Warren?) and your dividends are now only 67% of what they used to be, what do you think happens to the value of what you own? Yup, it goes down and by a bunch.  The value of the components of the S&P 500 as of Weds March 28 was $10,763,310 (source: www.indexarb.com). The dividend yield was approximately 1.93% or $207,969.  Well, individuals have to pay taxes, so let's pay the taxes, hold the macro assumptions the same (without commenting on their validity) and see what happens to the implied value:

		After taxes
		Current	New
S&P $ Dividend yield	$     207,969	$         176,774	$       117,710
Cost of Equity		6.7%	6.7%
Growth rate of dividend		5.1%	5.1%
Value per model		$    10,763,310	$    7,167,098
$ Value of S&P 3/28/10		$    10,763,310	$               -
% of S&P value 3/38		100%	67%

That 67% should look familiar to you by now. Your cash flows, if you think about it, are exactly what happens if someone takes 33% of your stock: you only have 67% of it left.  This is what is known as a tax on capital. This is what it does.

We should not get lost in the technical weeds: the purpose of this exercise is indicative. Analysts (aka 'propeller heads') can and should raise a host of problems/issues in this analysis, including but not limited to

• many tax payers are, at least for now, not taxable including pensions etc.
• a 5% growth rate is extremely optimistic, to be kind, and not static
• a 6.7% cost of equity is low  
• has the market has already priced this in? or
• has the market already priced in changes to or a reversal of this tax?

We know enough, however, to conclude broadly that this tax is not good for equity values and potentially very bad. It is certainly detrimental to individuals who were planning on dividend or interest income from savings to retire, educate their children, provide elder care, or otherwise pursue happiness. As a matter of course these changes will increase the ability of politicians to monetize their ability to dispense economic privilege through manipulation of the tax & regulatory code and will increase the price of that service... yes, you may read that as a rational increase the in the cost of corruption and the value of rent seeking behavior. And certainly, the value of barter & black market activity will greatly increase.

As to markets, investors will modify their behavior and seek:

• municipal debt
• investment vehicles where income is not subject to double taxation
• tax shelters in Roth & regular IRA's, but they will have less capacity to do so
• opportunities to arbitrage tax rates

One important tactical issue for planning: the coming increase of tax rates on long term capital gains goes effective next year and may induce a wave of selling.  If you're relying on the sale of assets with embedded long term gains to fund college, retirement, or anything else, you might want to consider the timing of your sales.  In addition to the selling induced by the higher capital gains tax, there may very well be a wave of selling induced by the conversion of regular IRA's to Roth IRAs. It could get very crowded in the fourth quarter, and you don't want to be the last in line waiting to get out before year end. This could be non-trivial.