
Federal Tax Rates, 1913 through December 2003
67
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PART 1 The Verdict of History
FIGURE
5-2
After-Tax Real Return for Various Federal Tax Brackets, 1802 through December 2006
ranges for the total real returns on Treasury bonds and the total real returns on municipal bonds, which are exempt from federal taxes, are displayed. Since municipal bond yields are generally lower than Treasurybond yields, the total return on Treasuries is higher than municipalbonds for untaxed investors, but lower for most taxable investors.The historical real after-tax returns for four tax brackets are displayed in Table 5-1. Since 1913, when the federal income tax was instituted, the after-tax real return on stocks has ranged from 6.3 percent foruntaxed investors to 2.8 percent for investors in the highest bracket whodo not defer their capital gains. For taxable bonds, the real annual returnranges from 1.9 to –0.7 percent, and in bills from 0.5 to –2.3 percent, depending on the tax bracket. Municipal bonds have yielded a 0.9 percentannual real return since the income tax was instituted.
CHAPTER 5 The Impact of Taxes on Stock and Bond Returns
TABLE
69
5–1
After-Tax Real Asset Returns, 1802 through December 2006: Compound Annual Rates of Return (%)*Gold
CPI
$0
BillsMuniTax BracketsBds$50K $150K Max
6.8
5.9
5.6
5.2
3.5
2.8
2.6
2.3
2.8
2.3
1.8
3.0
0.3
1.4
1871-2006
6.7
5.4
4.9
4.2
2.8
1.8
1.5
1.0
1.7
0.9
0.2 -0.3 2.0
0.4
2.1
1913-2006
6.3
4.4
3.7
2.8
1.9
0.5
0.0 -0.7 0.5 -0.6 -1.6 -2.3 0.9
0.4
3.3
I 1802-1870
7.0
7.0
7.0
7.0
4.8
4.8
4.8
4.8
5.1
5.1
5.1
5.1
5.0
0.2
0.1
II 1871-1925
6.6
6.5
6.4
6.2
3.7
3.7
3.6
3.4
3.2
3.1
3.0
2.7
3.4
-0.8
0.6
III 1926-2006
6.6
4.4
3.7
2.8
2.2
0.6
0.0 -0.6 0.7 -0.6 -1.6 -2.3 1.1
1.2
3.0
1946-2006
6.8
4.3
3.4
2.9
1.4 -0.6 -1.2 -1.7 0.6 -1.1 -2.5 -3.2 0.5
0.5
4.0
1946-1965
10.0 7.0
5.2
3.8 -1.2 -2.0 -2.7 -3.5 -0.8 -1.5 -2.3 -2.7 -0.6
-2.7
2.8
1966-1981
-0.4 -2.2 -3.0 -3.3 -4.2 -6.1 -7.0 -7.5 -0.2 -3.0 -5.2 -6.1 -1.0
8.8
7.0
1982-1999
13.6 9.4
9.1
9.1
8.4
4.9
4.5
4.4
2.9
0.8 -0.8 -1.7 2.7
-4.9
3.3
1982-2006
9.0
6.3
6.2
7.3
4.5
4.2
4.0
2.1
0.4 -0.9 -1.7 2.2
-1.2
3.1
Period
1802-2006
MajorSubperiods
$0
BondsTax Brackets$50K $150K Max
Postwar Periods
$0
StocksTax Brackets$50K $150K Max
6.4
1.5
*Federal income tax only. Assume one-year holding period for capital gains portion of return.
Despite the debilitating effect of taxes on equity accumulations,taxes cause the greatest damage to the returns on fixed-income investments. On an after-tax basis, an investor in the top tax bracket who put$1,000 in Treasury bills at the beginning of 1946 would have $138 aftertaxes and after inflation today, a loss in purchasing power of more than86 percent. Instead, a highest-bracket investor would have turned $1,000into over $5,719 by buying stocks, a 470 percent increase in purchasingpower.In fact, for someone in the highest tax bracket, short-term Treasurybills have yielded a negative after-tax real return since 1871, even lowerif state and local taxes are taken into account. In contrast, top-brackettaxable investors would have increased their purchasing power instocks 269-fold over the same period.
THE BENEFITS OF DEFERRING CAPITAL GAINS TAXESIn May 2003 President George W. Bush signed the Jobs and Growth Reconciliation Act of 2003, which reduced the highest tax rate on qualified
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PART 1 The Verdict of History
dividends and capital gains to 15 percent. Nevertheless, effective taxeson capital gains are still lower than on dividends since taxes on capitalgains are paid only when the asset is sold, not as the gain is accrued. Theadvantage of this tax deferral is that the return from capital gains accumulates at the higher before-tax rates rather than the after-tax rates as inthe case of dividends. I call the advantage of capital gains over dividendincome the “deferral benefit.”4For long-term investors the advantage of the deferral benefit can besubstantial. For example, take two stocks, one yielding 10 percent peryear in dividend income and the other yielding 10 percent solely in capital gains. Assume an individual is in a 30 percent taxable bracket, andthe capital gains and dividend tax rate is 15 percent. For an untaxed investor, both investments would yield identical 10 percent returns. Butthe after-tax yield on the dividend-paying stock is 8.5 percent per year,while, if the investor waits for 30 years before selling the capital-gainspaying stock, the after-tax return is 9.41 percent per year. This is only 59basis points less than the return of an untaxed investor.Therefore, from a tax standpoint, there is still bias for firms to deliver capital gains as opposed to dividend income. This is unfortunatesince, as we shall note in Chapter 9, dividend-paying stocks generallyyield better before- and after-tax returns than non-dividend-payingstocks. Dividends can be put on the same tax basis as capital gains if investors who reinvest their dividends back into the stock are allowed toobtain a tax deferral on reinvested dividends until the stock is sold.
INFLATION AND THE CAPITAL GAINS TAXIn the United States, capital gains taxes are paid on the difference between the price of an asset when it is purchased (its nominal price) andthe value (price) of that asset when it is sold, with no adjustment madefor inflation. This nominally based tax system means that an asset thatappreciates by less than the rate of inflation—resulting in a loss of purchasing power—will nevertheless be taxed upon sale.Although the appreciation of stock prices generally compensatesinvestors for increases in the rate of inflation, especially in the long run,a tax code based on nominal prices penalizes investors in an inflationaryenvironment. For a given real return, even a moderate inflation rate of 3percent causes an investor with a five-year average holding period to4It may be that firms that pay higher dividends have better incentives to provide shareholders withhigher total returns. This possibility is not explored in this chapter.
CHAPTER 5 The Impact of Taxes on Stock and Bond Returns
71
lose 31 basis points per year compared with the after-tax return thatwould result if the inflation rate were zero. If the inflation rate rises to 6percent, the decline in annual return is more than 65 basis points peryear. I call this effect the “inflation tax.” The inflation tax for various inflation rates and various holding periods under the current tax systemare displayed in Figure 5-3.5The inflation tax has a far more devastating effect on after-tax realreturns when the holding period is short than when it is long. This is because the more frequently an investor buys and sells assets, the more frequently the government can tax the capital gains. But even for long-terminvestors, the inflation tax reduces after-tax returns.5Figure 5-3 assumes a total real return of 7 percent (real appreciation of 5 percent, a dividend yieldof 2 percent), and tax rates of 15 percent on capital gains and dividend income. If inflation is 3 percent, the total before-tax return on stocks will be 10 percent in nominal terms.
FIGURE
5-3
Impact of Holding Period on Real After-Tax Returns
7%
Real After-Tax Return
6%5%4%3%1-Year Holding Period5-Year Holding Period10-Year Holding Period20-Year Holding Period30-Year Holding Period50-Year Holding Period
2%1%0%0%
2%
4%
6%
8%
10%
12%
Inflation Rate
14%
16%
18%
20%
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PART 1 The Verdict of History
There is considerable support, both inside and outside government, to make some adjustment for inflation in the tax system. In 1986,the U.S. Treasury proposed the indexation of capital gains, but this provision was never enacted into law. In 1997, the House of Representativesincluded capital gains indexation in its tax law, but it was removed byHouse-Senate conferees under threat of a presidential veto. Under theseplans, investors would pay taxes on only that portion of the gain (if any)that exceeded the increase in the price level over the holding period ofthe asset. Although this legislation is currently dormant, in recent yearsthe Federal Reserve has kept inflation low, and this has reduced the impact of the inflation tax.
INCREASINGLY FAVORABLE TAX FACTORS FOR EQUITIESIn recent years there have been some very favorable tax developmentsfor stocks. They include the following:1. Reduction in dividend and capital gains tax rates2. Lower inflation, which reduces the inflation tax imposed onnominal capital gains,3. Switch to capital gains from dividends, which increases the deferral benefitThe capital gains tax rate has been reduced from a maximum of 35percent in 1978 to 15 percent in 2003. Until 2003, when the tax rate ondividends was for the first time decoupled from the tax rate on ordinaryincome, the tax rate on dividends ranged from a high of 90 percent in theimmediate post–World War II years to 33 percent in 1998 and then to thespecial rate of 15 percent in 2003. (See the appendix at the end of thechapter for the history of the tax code.)Since the tax law is based on only nominal values uncorrected forinflation, inflation imposes an additional tax on capital gains. The inflation rate has fallen from double-digit levels in 1979 to the 2 to 3 percentlevel in 2007. Since tax brackets are indexed to inflation, the tax rate ondividends is not directly affected by inflation. Furthermore, since thecapital gains tax is based on realizations instead of accruals, firms havebeen buying back shares in lieu of paying dividends and generatingmore capital gains income. As a result, the average dividend yield hasfallen from about 5 percent before 1980 to only 2 percent in 2007.It can be calculated that all these factors have increased the realafter-tax return on stocks by more than 2 percentage points over the past30 years for a given before-tax return. Although the real after-tax return
CHAPTER 5 The Impact of Taxes on Stock and Bond Returns
73
on bonds has also increased as a result of the drop in the tax rates on ordinary income, the increase in the real return on stocks has been greater.In any equilibrium model of asset pricing, the favorable tax factors forequities suggest that stocks should be priced at a higher multiple ofearnings. This will be discussed in Chapter 8.
STOCKS OR BONDS IN TAX-DEFERRED ACCOUNTS?The most important savings vehicles for many individuals are their taxdeferred accounts (TDAs) such as Keogh, IRA, and 401(k) plans. Manyinvestors hold most of their stock (if they hold any at all) in their tax-deferred accounts, while they hold primarily fixed-income assets in theirtaxable accounts.Yet many of the recent changes in the tax laws argue that investorsshould do the opposite. Dividends will enjoy the lower tax rates and appreciation on shares will gain the lower capital gains tax advantage onlyif they are held in taxable accounts. This is because when a tax-deferredaccount is cashed out at retirement, an individual pays the full ordinaryincome tax on the entire withdrawal regardless of how much of the accumulation has been realized through capital gains and how muchthrough dividend income.The above counsel, however, ignores two factors. First, if you arean active trader or buy mutual funds that actively trade, then there maybe significant capital gains realized, some short run, that would be bestkept in a tax-deferred account. Trading in tax-deferred accounts alsodoes not require complicated tax computations since there are no taxespaid until money is withdrawn and the source of the money is of noconsequence.Second, although the government taxes your capital gains and dividends at ordinary rates when withdrawn from a TDA, the governmentalso shares more of the risk. If you realize a capital loss in a taxable account, the government limits your ability to offset this loss against ordinary income. However, when funds are withdrawn from a tax-deferredaccount, the full withdrawal is treated as taxable income, so that alllosses become totally deductible from taxable income. Therefore, there isless after-tax risk putting your money in tax-deferred accounts.When all the factors are considered, it is better for most investors tohold stocks in their taxable accounts, unless they are active traders. Ifyou have a long horizon, the possibility that you will have a loss in yourstock accounts is minimal, so the loss-sharing aspect of TDAs is lessimportant. It is advisable, however, to hold stocks that do not pay tax-
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PART 1 The Verdict of History
qualified dividends, such as REITs and other income trusts, in one’s taxdeferred account to avoid current taxes. However, some risk-averse investors who are reluctant to hold stocks in their personal accountsbecause of short-term volatility find it easier to hold stocks in their retirement accounts where they have a longer-term perspective and maybe better able to tolerate short-term losses.
CONCLUSIONTax planning is important to maximize returns from financial assets.Because of favorable dividend and capital gains tax rates and the potential to defer those capital gains taxes, stocks hold a significant tax advantage over fixed-income assets. These advantages have risen inrecent years as the capital gains and dividend tax has been reduced, inflation has remained low, and firms have repurchased shares to increasecapital gains. These favorable developments have increased the aftertax return of equities by more than 2 percentage points over the averageafter-tax return of the past 50 years. As favorable as stocks are overbonds for long-term investors, the advantage of equities is even greaterfor the taxable investor.
APPENDIX: HISTORY OF THE TAX CODEFederal income tax was first collected under the Revenue Act of 1913,when the Sixteenth Amendment to the U.S. Constitution was ratified.Until 1921 there was no tax preference given to capital gains income.When tax rates were increased sharply during World War I, investorsrefrained from realizing gains and complained to Congress about thetax consequences of selling their assets. Congress was persuaded thatsuch “frozen portfolios” were detrimental to the efficient allocation ofcapital, and so in 1922 a maximum tax rate of 12.5 percent was established on capital gains income. This rate became effective when taxableincome reached $30,000, which is equivalent to about $240,000 intoday’s dollars.In 1934, a new tax code was enacted that, for the first time, excludeda portion of capital gains from taxable income. This exclusion allowedmiddle-income investors, and not just the rich, to enjoy the tax benefitsof capital gains income. The excluded portion of the gain depended onthe length of time that the asset was held; there was no exclusion if theasset was held 1 year or less, but the exclusion was increased to 70 percent if the asset was held more than 10 years. Since marginal tax rates
CHAPTER 5 The Impact of Taxes on Stock and Bond Returns
75
ranged up to 79 percent in 1936, the effective maximum tax on verylong-term gains was reduced to about 24 percent.In 1938, the tax code was amended again to provide for a 50 percentexclusion of capital gains income if an asset was held more than 18months, but in no case would the tax exceed 15 percent on such capitalgains. The maximum rate on capital gains income was raised to 25 percent in 1942, but the holding period was reduced to 6 months. Except fora 1 percent surtax that raised the maximum rate to 26 percent during theKorean War, the 25 percent rate held until 1969.In 1969, the maximum tax rate on capital gains in excess of $50,000was phased out over a number of years, so ultimately the 50 percent exclusion applied to all tax rates. Since the maximum rate on ordinary income was 70 percent, this meant the maximum tax rate on capital gainsrose to 35 percent by 1973. In 1978, the exclusion was raised to 60 percent, which lowered the effective maximum tax rate on capital gains to28 percent. When the maximum tax rate on ordinary income was reduced to 50 percent in 1982, the maximum tax rate on capital gains wasagain reduced to 20 percent.In 1986, the tax code was extensively altered to reduce and simplifythe tax structure and ultimately eliminate the distinction between capital gains and ordinary income. By 1988, the maximum tax rates for bothcapital gains and ordinary income were identical, at 33 percent. For thefirst time since 1922, there was no preference for capital gains income. In1990, the top rate was lowered to 28 percent on both ordinary and capital gains income. In 1991, a slight wedge was reopened between capitalgains and ordinary income: the top rate on the latter was raised to 31percent, while the former remained at 28 percent. In 1993, PresidentClinton raised tax rates again, increasing the top rate on ordinary income to 39.6 percent while keeping the capital gains tax unchanged. In1997, Congress lowered the maximum capital gains tax to 20 percent forassets held more than 18 months and the following year returned to the12-month capital gains period. Starting in 2001, investors could take advantage of a new 18 percent top capital gains rate for assets held at least5 years.In 2003 President Bush signed into law legislation that lowered thetop rate on capital gains and qualified dividend income to 15 percent.Qualified dividend income must come from taxable enterprises, not“flow through” organizations such as real estate investment trusts or investment companies.
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6
CHAPTER
THE INVESTMENTVIEW OF STOCKSHow Fickle MarketsOverwhelm Historical FactsThe “new-era” doctrine—that “good” stocks (or “blue chips”) weresound investments regardless of how high the price paid for them—was at the bottom only a means of rationalizing under the title of “investment” the well-nigh universal capitulation to the gambling fever.B E N J A M I N G R A H A M A N D D AV I D D O D D , 1 9 3 4 1
Investing in stocks has become a national hobby and a national obsession. To update Marx, it is the religion of the masses.ROGER LOWENSTEIN, 19962
1
Benjamin Graham and David Dodd, Security Analysis, New York: McGraw-Hill, 1934, p. 11.Roger Lowenstein, “A Common Market: The Public’s Zeal to Invest,” Wall Street Journal, September 9, 1996, p. A11.2
77Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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PART 1 The Verdict of History
It was a seasonally cool Monday evening on October 14, 1929, when Irving Fisher arrived at the Builders’ Exchange Club at 2 Park Avenue inNew York City. Fisher, a professor of economics at Yale University andthe most renowned economist of his time, was scheduled to address themonthly meeting of the Purchasing Agents Association.The Yale economist, often called the founder of modern capital theory, was no mere academic. He actively analyzed and forecast financialmarket conditions, wrote dozens of newsletters on topics ranging fromhealth to investments, and created a highly successful card-indexingfirm based on one of his own patented inventions. Despite hailing froma modest background, his personal wealth in the summer of 1929 exceeded $10 million.3Association members and the press crowded the meeting room.Fisher had intended to defend investment trusts, the forerunner oftoday’s mutual funds. But the audience was most eager to hear his viewson the stock market, as they had been nervous since early Septemberwhen Roger Babson, businessman and market seer, predicted a “terrific”crash in stock prices.4 Fisher had dismissed Babson’s pessimism, notingthat he had been bearish for some time. But the public sought to be reassured by the great man who had championed stocks for so long.The audience was not disappointed. After a few introductory remarks, Fisher uttered a sentence that, much to his regret, became one ofthe most-quoted phrases in stock market history: “Stock prices,” he proclaimed, “have reached what looks like a permanently high plateau.”5On October 29, two weeks to the day after Fisher’s speech, stockscrashed. His “high plateau” turned instead into a bottomless abyss. Thenext three years witnessed the most devastating market collapse in history. Like Neville Chamberlain’s proud claim that the “agreement”Adolph Hitler signed in Munich in September 1938 guaranteed “peacein our time,” Fisher’s stock market prediction stands as a memorial tothe folly of great men who failed to envision impending disaster.After the crash, it made little difference to the public that Fisher hadearlier correctly forecast the bull market in the 1920s, or recognized theimportance of the Federal Reserve in creating a favorable economic climate, or properly defended investment trusts, the forerunners of today’smutual funds, as the best way that the public could participate in thestock market. After 1929, his reputation was shattered.3
Robert Loring Allen, Irving Fisher: A Biography, Cambridge: Blackwell, 1993, p. 206.Commercial and Financial Chronicle, September 7, 1929.5“Fisher Sees Stocks Permanently High,” New York Times, October 16, 1929, p. 2.4
CHAPTER 6 The Investment View of Stocks
79
But one should hesitate to render too harsh a judgment on Fisher’sanalysis. By the end of 1929, stock prices had recovered nearly 50 percentof their losses, and they would have likely continued upward had it notbeen for the disastrous performance of the Federal Reserve, an institution into which Fisher and many investors put their faith.As the central bank stood by when the financial system collapsedaround it, the most vicious bear market in history took hold. The 1930swould leave an indelible mark on the psyches of all investors. As happened so often throughout history, the data that confirmed the longterm superiority of stocks and served as the rationale for the marketadvance were dismissed as investors dumped stocks regardless of theirintrinsic value. Public and professional opinions about stocks are asvolatile as the markets themselves.
EARLY VIEWS OF STOCK INVESTINGThroughout the nineteenth century, stocks were deemed the province ofspeculators and insiders but certainly not conservative investors. It wasnot until the early twentieth century that researchers came to realize thatstocks, as a class, might be suitable investments under certain economicconditions for investors outside those traditional channels. In the early1920s, Irving Fisher maintained that stocks would indeed be superior tobonds during inflationary times although common shares would likelyunderperform bonds during periods of declining prices.6 This view became the conventional wisdom of the early twentieth century.Edgar Lawrence Smith, a financial analyst and investment managerof the 1920s, exploded this popular conception. Smith was the first todemonstrate that accumulations in a diversified portfolio of commonstocks outperformed bonds not only when commodity prices were rising but also when prices were falling. Smith published his studies in1925 in a book entitled Common Stocks as Long-Term Investments. In the introduction he stated:These studies are a record of a failure—the failure of facts to sustain a preconceived theory, . . . [the theory being] that high-grade bonds had provedto be better investments during periods of [falling commodity prices].7
By examining stock returns back to the Civil War, Smith found thatnot only did stocks beat bonds whether prices were rising or falling butthere was also a very small chance that you would have to wait a long67
Irving Fisher, How to Invest When Prices Are Rising, Scranton, Pa.: G. Lynn Sumner & Co., 1912.Edgar L. Smith, Common Stocks as Long-Term Investments, New York: Macmillan, 1925, p. v.
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PART 1 The Verdict of History
time (which he put at 6 and, at most, 15 years) before being able to sellyour stocks at a profit. He concluded:We have found that there is a force at work in our common stock holdingswhich tends ever toward increasing their principal value. . . . [U]nless wehave had the extreme misfortune to invest at the very peak of a noteworthyrise, those periods in which the average market value of our holding remainsless than the amount we paid for them are of comparatively short duration.Our hazard even in such extreme cases appears to be that of time alone.8
Smith’s conclusion was right not only historically but also prospectively. It took just over 15 years to recover the money invested at the 1929peak, following a crash far worse than Smith had ever examined. Andsince World War II, the recovery period for stocks has been better thanSmith’s wildest dreams. The longest it has ever taken since 1945 to recover an original investment in the stock market (including reinvesteddividends) was the five-year, eight-month period from August 2000through April 2006.
The Influence of Smith’s WorkSmith wrote his book at the outset of one of the greatest bull markets inour history. Its conclusions caused a sensation in both academic and investing circles. The prestigious weekly The Economist stated, “Every intelligent investor and stockbroker should study Mr. Smith’s mostinteresting little book, and examine the tests individually and their verysurprising results.”9Irving Fisher saw Smith’s study as a confirmation of his own longheld belief that bonds were overrated as safe investments in a worldwith uncertain inflation. Fisher summarized the new findings:It seems, then, that the market overrates the safety of “safe” securities andpays too much for them, that it underrates the risk of risky securities andpays too little for them, that it pays too much for immediate and too littlefor remote returns, and finally, that it mistakes the steadiness of money income from a bond for a steadiness of real income which it does not possess. In steadiness of real income, or purchasing power, a list of diversifiedcommon stocks surpasses bonds.108
Ibid., p. 81.“Ordinary Shares as Investments,” The Economist, June 6, 1925, p. 1141.10From the Foreword by Irving Fisher in Kenneth S. Van Strum, Investing in Purchasing Power, NewYork: Barron’s, 1925, p. vii. Van Strum, a writer for Barron’s weekly, followed up and confirmedSmith’s research.9
CHAPTER 6 The Investment View of Stocks
81
Smith’s ideas quickly crossed the Atlantic and were the subject ofmuch discussion in Great Britain. John Maynard Keynes, the greatBritish economist and originator of the business cycle theory that became the accepted paradigm for future generations, reviewed Smith’sbook with much excitement. Keynes stated:The results are striking. Mr. Smith finds in almost every case, not onlywhen prices were rising, but also when they were falling, that commonstocks have turned out best in the long-run, indeed, markedly so. . . . Thisactual experience in the United States over the past fifty years affordsprima facie evidence that the prejudice of investors and investing institutions in favor of bonds as being “safe” and against common stocks as having, even the best of them, a “speculative” flavor, has led to a relativeover-valuation of bonds and under-valuation of common stocks.11
Money managers were also quick to realize the impact of Smith’swork. Hartley Withers wrote in the London Investors Chronicle and MoneyMarket Review:Old-fashioned investors and their old-fashioned advisers have so longbeen in the habit of looking on all holdings of ordinary shares or commonstocks as something rather naughty and speculative, that one feels a certain amount of hesitation in even ventilating the view that is now rapidlygaining acceptance that ordinary shares, under certain conditions, are really safer than [bonds], even though the latter may be of the variety whichis commonly called “gilt-edged.”12
Smith’s writings were published in such prestigious journals as theReview of Economic Statistics and the Journal of the American Statistical Association.13 Further research confirmed his results. Smith acquired an international following when Siegfried Stern published an extensive studyof returns in common stock in 13 European countries from the onset ofWorld War I through 1928. Stern’s study showed that the advantage ofinvesting in common stocks over bonds and other financial investmentsextended far beyond America’s financial markets.14
11John Maynard Ke