EFFECT OF A CHANGE IN TAX RATES ON STOCK MARKET PRICES

Over the years, a number of well-known stockholders have said: “The way the stock market works has been a puzzle to us.”  

Abstract

A pure and theoretical macroeconomics analysis predicts that a change in tax rates can have an effect on stock market prices. However, this effect cannot be found anywhere in the United States (US) stock market data. This is puzzling to those interested in the stock market. This quandary compels me to address the problem. To do so, I utilize the rational expectations and efficient stock market paradigms and then apply them to the change in tax rates. The net result is that only an unanticipated change in tax rates could impact stock market prices. However, the implementation of such an unanticipated change in tax rates is impossible in a democratic country such as the US.  

I. INTRODUCTION 

According to a pure and theoretical macroeconomics analysis, the effects of a change in tax rates on stock market prices would follow this pattern. An increase in tax rates lowers stock market returns. The stockholders’ ability to spend will decrease and they will be less inclined to invest in the stocks. As a result, stock market prices will decrease. A decrease in tax rates would produce opposite effects. These two kinds of cause and effect relationships would remain the same regardless of the nature of the stock market investor. Though my pure and theoretical reasoning predicts that a change in tax rates can impact stock market prices, US stock market data indicate no effect. The analysis of this dichotomy is the purpose of this research paper.     

II. WHY IS THERE A DICHOTOMY BETWEEN THE THEORETICAL EFFECT OF A CHANGE IN TAX RATES ON STOCK MARKET PRICES AND US STOCK MARKET DATA?   

Two financial market paradigms are crucial in explaining that dichotomy. They are (1) rational expectations, and (2) the efficient stock hypothesis.  

1. Rational expectations

Beginning in the late 1960s and early 1970s, rational expectations quickly replaced the modeling of expectations as an adaptive process. Today, they are used as a fundamental premise for many contemporary macroeconomics models that study the dynamics of the economy over time, such as those of contemporary finance. For example, the value of a share of stock is dependent on the expected future income from that stock. 

Although the future is not fully predictable and is, instead, partially predictable, rational expectations assume that competitive economic agents’ expectations are correct on average; i.e., they are not systematically biased and the forecasted outcomes do not differ systematically from market equilibrium results. While forming rational expectations, competitive economic agents, through the use of all available information, are not supposed to make any systematic errors. Any deviation from the collective perfect expectations is merely random. Predictions formed under the rational expectations hypothesis are viewed as the optimal forecast and as the perfect foresight. These predictions produce actual values of variables that, on average, equal the expectations. Clearly, the hypothesis of rational expectations means that competitive economic agents forecast in such a way as to minimize forecast errors, subject to the information and decision-making constraints that confront them. It does not mean that they never make forecast errors but that such errors have no serial correlation and no systematic component. Rational expectations imply that a change in economic policy will not have any effect on real variables. Expectations formed by competitive economic agents about a change in economic policy, with an almost perfect knowledge of the structure of the economy, will adjust immediately and offset the impact of such a change. In economics literature, especially in macroeconomics, this phenomenon is referred to as “policy ineffectiveness proposition,” “policy invariance proposition,” or “policy neutrality.” 

By applying the rational expectations hypothesis to a change in tax rates, I reach the following conclusions: If the US government decides to change its tax rates, competitive and sophisticated intelligent economic agents involved in the stock market will anticipate the effect of that change. In turn, this process will counteract the effect of the change in tax rates and the end result will be that stock market prices will remain unaffected.    

2. Efficient stock market hypothesis 

For some time in the past, the efficient stock market hypothesis was controversial. Now, this controversy has ended. The financial theorist’s faith in the efficient stock market is unshakable. As it will appear, the efficient stock market hypothesis is, in some ways, closely related to the rational expectations paradigm. 

(a) What does the efficient stock market hypothesis mean? 

The efficient stock market hypothesis supposes that large numbers of rational profit-maximizers actively compete, with each trying to predict future market values of individual stocks by using important and current information. In this way, stock market prices are unbiased because they reflect all known and available information and the collective beliefs of all stock market investors about stock market future prospects. In the efficient stock market hypothesis, prices represent an aggregation of the probabilities of all future stock market returns, based on the best information available at the time. The efficient stock market hypothesis does not require that information be correct. It does not exclude the existence of unusually successful stock market investors or funds occurring through chance. All that it requires is that stock market investors’ reactions be random and follow a normal distribution pattern so that the net effect on prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). In other words, it does not allow an investor to outperform consistently the market by using any information that the stock market already knows. Luck, on the part of an investor, would be an exception. The reason is that, the stock market, as a whole, can be considered to be always right. Although, in the presence of new information, some investors may overreact while others may under-react, this new information does not affect stock market prices. This analysis is corroborated by a study of the 50 largest one-day stock market movements in the post-war U.S.    

To sum up, the efficient stock market hypothesis holds that stocks are always correctly priced because all information that is known about the stock market is fully reflected in their prices within a short amount of time. The stock market continually adjusts all prices to reflect new information. Only changes in fundamental factors, such as profits or dividends, could affect stock market prices. In the absence of change in fundamental information, all stock market price movement is random; i.e., non-trending. In an efficient stock market, competition among the many intelligent stock market participants leads to a situation where actual prices of stocks already reflect the effects of information, which, as of now, the stock market expects to take place in the future. At that point in time, the actual price of a stock will be a good estimate of its intrinsic value. 

(b) How does the efficient stock market hypothesis help to explain the dichotomy between theoretical predictions of a change in tax rates on stock market prices and US stock market data?   

All that the efficient stock market hypothesis requires is that stock market prices fully reflect all the information available on a change in tax rates. Prices respond only to unexpected news and no excess returns can be earned by trading on that information. In this way, prices are optimal estimates of true stock market investment value at all times. The rationale is that the efficient stock market hypothesis requires the stock market prices adjust fully and instantaneously to all information concerning a change in tax rates in anticipation of that change. In other words, when information about a change in tax rates becomes available, prices react and adjust before the change in tax rates. Once a change in tax rates is announced, prices react in anticipation of that change in tax rates to be passed as a law. When the change in tax rates starts, prices have already fully reacted, adjusted. There is, subsequently, no effect.    

Stated differently, the stock market correctly evaluates the implications of a change in tax rates for stock market prices and fully incorporates these evaluations in its prices by the time that change in tax rates actually occurs. In reaction to a change in tax rates, the stock market not only makes good forecasts of the change in tax rates but those forecasts are fully incorporated into the stock market prices by the time the announcement of the change in tax rates.  

More specifically, the effect of a change in tax rates on stock market prices proceeds as follows: When a change in tax rates is announced or anticipated, the stock market interprets this, and correctly so, as greatly improving the probability that prices will soon be substantially changed. There is a full and automatic prices’ adjustment in anticipation of a change in tax rates. When the change in tax rates actually takes place, prices have already resumed their normal relationships because, from this point onward, the average residuals are small and randomly scattered around zero. On average, the prices will not experience any change in the period after the adjustment but rather will behave independently from the change in tax rates. 

In sum, once all available information about a change in tax rates is properly considered, a change in tax rates per se has no effect on stock market prices. In presence of a change in tax rates, stock market prices adjust sufficiently to keep stock market prices unaffected by the change. In equilibrium, stocks are priced to equalize after-tax stock returns. 

III. CONCLUSION 

The rational expectations and efficient stock market paradigms explain why the effect of a change in tax rates on stock market prices does not appear in the US stock market data. Once the stock market has full knowledge on a projected change in tax rates, it immediately reacts and corrects stock prices. When a change in tax rates actually occurs, the stock market has already adjusted its prices and there is no further reaction. In other words, when a change in tax rates is implemented, stock prices remain as they were before the actual change in tax rates. As the US stock market data include the effects of a policy when it is implemented, they will not display the instantaneous effect of a change in tax rates on stock market prices. A number of outstanding scholarly works on relatively similar subjects corroborated this result. The rationale behind all of this reasoning is that the stock market reacts to information about an economic policy and not to the actual implementation of that policy.      

By contrast, it seems that an unanticipated change in tax rates could produce an effect on stock market prices. This effect might be evidenced in the US stock market data. However, as I developed in the footnote 13, an unanticipated change in tax rates is not easy to implement in the US economy. In the US, every change in tax rates is publicly debated within Congress. As competitive investors are not myopic, they will integrate all information they would get from U.S. Congressional debates on the change in tax rates in the stock market prices. In other words, an unanticipated and unannounced change in tax rates will most likely be reflected in stock market investment decisions. In this way, the outcome is likely to be the same as the one I reached when analyzing the effect of an anticipated change in tax rates on stock market prices.      

The end result of the above analysis is that it is impossible to read the effects of a change in tax rates on stock market prices in U.S. stock market data. This conclusion remains the same even if the U.S. government attempts to implement an unanticipated change in tax rates. An unanticipated change in tax rates will hardly work in the U.S. economy. 

June 2015

Done by Peter, PhD