The Tax Policy Center recently published a study that breaks down the ownership of American equities. The findings are astounding. Compared to 1965, ownership of equities in taxable accounts is down roughly 80%. The bulk of equities are now owned in tax-deferred retirement accounts:
This shift, which began in the late 1960s, was accelerated by the advent of Individual Retirement Accounts in 1974, and by defined contributions plans such as 401(k)s which became available in 1978. The Tax Policy Center estimates that some 37% of US equities are now held in tax-deferred retirement accounts of some kind.
The benefit to investors of this ownership shift from taxable to tax-deferred has been immense. Dividends were taxed at the high rates of ordinary income up until 2003, and long-term capital gains taxes, while currently low relative to history, were elevated for long periods during much of the last 50 years (via the Tax Policy Center):
There are possible implications for equity valuations as a result of this change in ownership structure. As Philosophical Economics has written, the current tax environment is very favorable for equity ownership. Not only are dividend and capital gains taxes low by historical standards, the vast majority of equity investors are not currently subject to taxes of any kind by virtue of tax-deferral, as outlined above. This means that investors are likely to continue to be content with lower nominal returns than they would be if they were subject to taxation.
Another way of saying this is that it is conceivable that valuation multiples will remain above their long-term historical averages because most investors, by virtue of their tax-deferred holdings, do not have to clear the tax obstacle each year on their way to achieving historically similar returns. This logic is no different from an investor in tax-free municipal bonds, who is satisfied with a nominal yield – and thus a lower nominal return – than his counterpart who invests in taxable bonds.
This, of course, is not to say that stocks are currently cheap, or that a market drop will not happen. Rather, it is simply an observation that while higher expected returns go hand-in-hand with lower starting valuation multiples, it is conceivable, as Ben Carlson has pointed out, that net returns – the returns investors receive after inflation, fees, and taxation – may not be all that different from historical averages, even if starting from elevated valuations, simply because the hurdle of variables – particularly that of taxation – has been lowered.
Here is an example of what I mean. Comparing 1965 to 2017, one can see how a lower tax liability combined with lower investment expenses, could lead to materially similar net returns as in the past, even while starting from much lower nominal returns:
Disclosure: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
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