Health Taxes and Stocks
A Medicare tax on investment income and a proposed hike in the capital gains rate won't snuff out the rally in stocks.
Let me state at the outset that I am very disappointed in President Obama's new health-care legislation. It does very little to address the failings of our current health-care system, the growth of state bureaucracies to dictate insurance coverage, and Medicare costs that threaten to overwhelm our economy as the baby-boomers retire. Nevertheless, it is important to analyze the new law's impact on financial markets.
The biggest negative is the surprise imposition of a 3.8% Medicare tax on investment income -- the first time unearned income has been subject to such a tax. Although the tax is now set to hit only "high income" individuals and families (with adjusted gross income of $200,000 for individuals and $250,000 for joint filers), those are the people who own most shares of stock.
On a different front, Obama is also proposing to raise the top tax rate on capital gains and dividends from 15% to 20% when the Bush tax cuts expire next year. So the combined tax rate on capital gains and dividend income could rise to a maximum of 23.8%, a 59% increase over the current 15% level. Under Obama's proposals, taxes on interest income would be even higher. Interest is taxed as ordinary income, and the President wants to raise the top income-tax rate from 35% to 39.6%. And that doesn't include the new Medicare tax.
Nevertheless, the sharp rise in the capital-gains tax is not sufficient to snuff out the rally in stocks. We have experienced bull markets when the tax rates on capital gains were even higher. In fact, low taxes on capital gains are a relatively recent phenomenon. In 1988, the maximum rate for both capital gains and ordinary income was 33%, almost ten percentage points above the level that Obama now proposes for capital gains. In 1990, the top tax rate on capital gains was lowered to 28% and kept at that level until 1997, when the rate was reduced to 20%.
So Obama's proposed top capital-gains rate of 23.8% is not unusually high by historical standards. And the tax rate Obama would impose on dividend income is still lower than the rate on earned income and interest income. So despite the potential tax increases, stocks would still receive substantial preferential treatment.
Dodging bullets. Under Obama's plan, municipal bonds may seem like winners because they maintain their tax-exempt status. And yields on the highest-grade muni bonds have recently been as high as those on taxable Treasuries. But investors must be careful. I expect long-term interest rates to rise, and rising rates will mean capital losses for holders of any bond, tax-exempt or not. Stocks will do much better in an environment of rising rates because rising rates indicate a stronger economy, which boosts corporate profits.
Furthermore, stock prices have for some time taken into account the negatives of health-care reform. Since the market hit its all-time high in October 2007, the health-care industry has actually performed much better than Standard & Poor's 500-stock index.
In addition, the pharmaceutical industry has managed to dodge a lot of bullets. For example, direct price negotiations between Medicare and the drug industry are still prohibited, as is the importation of foreign drugs. Although Obama's plan does call for higher taxes on the drug industry, some analysts believe that the increase in drug sales to the newly insured will offset those costs and might be a net gain for the industry. Managed-care firms could turn out to be the biggest winners in health care. These firms and insurers were spared having to compete with a "public option" and can look forward to millions of new customers.
Finally, the new Medicare tax doesn't take effect until 2013. By that time, a new president or a different Congress could modify or eliminate Obama's plan.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton school and the author of Stocks for the Long Run and The Future for Investors.