The uncertainty over looming tax increases is starting to affect both
investing and corporate decision-making.
The economy remains the biggest factor in many investors' and businesses'
decisions. But worries over whether Congress will extend some of the expiring
Bush-era tax breaks are emerging as another important one.
Stock prices of utilities, for example, recently have appeared to be
factoring in the possibility of significantly higher dividend taxes next year,
several analysts say. Some companies are pumping up dividend payments this year
to beat the possible 2011 tax increase, and their shares have rallied.
Small-business owners say unease about tax policy, along with the economy,
has led them to hold off on hiring and investment. And many advisers are
encouraging well-to-do clients to sell appreciated assets to avoid higher
capital-gains taxes.
Congress hasn't decided how to address the tax cuts from the George W. Bush
administration, which are set to expire Dec. 31. President Barack Obama proposes
to allow taxes on dividends and capital gains to rise to 20% from the current
15% for higher earners, defined as families with incomes of more than $250,000.
But many congressional Democrats want to let dividend tax rates, along with
ordinary income rates, rise next year for higher earners to as much as
39.6%.
A senior House aide said late last month that Democratic leaders hadn't
decided yet whether to end the current rates on dividends and capital gains for
higher earners, or to extend them for everyone. Republicans are largely united
in calling for a complete extension, although House GOP Leader John Boehner on
Sunday signaled a measure of flexibility. If Congress takes no action,
investment taxes would go up virtually across the board.
The broadest impact of higher investment taxes could come on financial
markets. But analysts and economists differ over the likely effect.
A July analysis by Barclays Capital suggested that increasing taxes on
investment income, as many Democrats advocate, could trim about 9% off the
S&P 500 index. Talley Leger, vice president of U.S. portfolio strategy for
Barclays Capital, called it "a potential headwind for stocks for the next couple
of years."
A 2005 study by three economists at the Federal Reserve, looking back at the
market response to the 2003 Bush tax cuts on dividends, concluded there wasn't a
significant impact on overall stock values.
Alan Auerbach, a professor at the University of California at Berkeley who
also has studied the effect of the Bush tax cuts, said the evidence suggested
that repealing the changes probably would produce a "small negative effect" on
financial markets.
Citigroup Global Markets forecasts that if all the proposals to raise
dividend tax rates take effect for higher earners, investors could pay an
additional $39 billion in taxes in 2013.
"That's a big effect, and probably a bit bigger than some market participants
believe," said Steven Wieting, U.S. economist at Citigroup Global Markets.
There are signs that tax concerns have been affecting a range of transactions
on the ground. Analysts say spreads between utility-stock dividend yields and
yields on some other securities recently have reflected expectations of a top
dividend tax rate in the low-30% range.
"The stocks could initially fall if dividend tax rates reset to marginal
rates, but we don't think it will be permanent," said Dan Eggers, a utility
equity research analyst at Credit Suisse Group in New York.
Some companies are squeezing in big dividends before year's end. In
anticipation of its conversion to a real-estate investment trust, Weyerhaeuser
Co. plans a $5.6 billion accumulated-earnings dividend payout this year, most of
it in the form of stock. Pharmaceutical company Warner Chilcott PLC has arranged
to borrow more than $2 billion to make an extraordinary dividend payment of
$8.50 a share to shareholders.
While dividends are getting most of the attention, wealthy investors also are
facing big incentives to realize capital gains by selling assets.
"We advise people that if they have gains to take or oversize positions that
need to be diversified, sell them before the end of the year, rather than wait
and pay higher taxes," said Sam Katzman, chief investment officer at
Constellation Wealth Advisors in New York.
Small-business owners, especially older ones, also face tax incentives to
sell soon.
"If someone is planning on selling a business, they should do it now," said
Chris Walters, an executive vice president based in Pasadena, Calif., at
CitizensTrust, the wealth management arm of Citizens Business Bank.
Some are hesitating, hoping for higher prices in the future. And business
owners who sell now can face risks, because of the way such deals may be
structured. Chris Hesse, head of the tax practice at LeMaster Daniels in
Spokane, Wash., said a client in his early 60s sold his remaining shares in a
business in a 10-year installment deal, and chose to pay all the tax at once
this year, in anticipation of higher rates in the future. That looks like a
smart strategy—unless the buyer can't make the future payments.
The prospect of higher taxes in 2011 and beyond also could be weighing on
business owners' operational decision-making. In its July survey of
small-business owners, the National Federation of Independent Business found
that 22% of small businesses said the most important problem they faced was
taxes, up from 19% a year earlier. More businesses—29%—identified poor sales as
their No. 1 problem, but that was down from 34% a year earlier.
Democrats say that less than 3% of small-business owners would be affected by
changes in tax rates for high earners. Republicans counter that the changes
would affect roughly half of all such income, possibly more.
"It's like deer in the headlights. Nobody is doing much of anything about
expanding or hiring or investing in new equipment," said Ken Keith, owner of
Kasbar Inc., a Winston-Salem, N.C., accounting firm that works with small
businesses.
Target Plastics Inc., a Salem, Ore., maker of custom plastic products, used
to have seven employees, but now it has only two full-time workers, with an
additional person working half-time, said owner Melissa Hescock.
"I've basically cut back because of the amount of taxes," Ms. Hescock said,
including recent state increases and anticipated future federal boosts. "I have
fewer people doing more work."
Write to John D. McKinnon at
john.mckinnon@wsj.com and Justin Lahart
at
justin.lahart@wsj.com 
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