Budget Deal May Fuel Stock Rally Lower Taxes On Capital Gains, Ira Changes Give Investors Incentives To Buy Stocks

The new federal budget agreement could throw fuel on an already incendiary stock market by giving investors another reason - as if they needed one - to buy equities.

The legislation would cut capital gains taxes, making long-term stock market gains worth more. It would make Individual Retirement Accounts more attractive by allowing investors to use them for first-time home purchases and college education costs.

“It is wildly bullish,” Peter Canelo, U.S. investment strategist at Morgan Stanley Dean Witter, said of the tentative tax and budget-balancing deal struck Monday.

The agreement would cut capital gains taxes, which are paid on profits from the sale of stocks, bonds and other investments. Retroactive to May 7, 1997, capital gains rates for the wealthiest investors would drop from a maximum of 28 percent to 20 percent, and from 15 percent to 10 percent for the lowest income bracket.

This actually could be a signal for investors to book some of their paper profits by selling stocks that have risen sharply the past few years.

“I have not taken capital gains for six years,” said William Chatlos, a retired corporate consultant in North Caldwell, N.J.

“It is clear that I and millions of others like me will use this opportunity to free up enormous amounts of capital. The market could take a temporary short-term pounding by people selling,” but eventually that money will find its way back to the stock market, Chatlos said.

Canelo agreed that a sell-off, if it does happen, will be short-lived. He noted that the stock market did decline in October 1978 when Congress cut capital gains taxes, but that was because the Federal Reserve also raised interest rates.

Stocks also tumbled after a 1981 tax cut, but that was when long-term bond yields were above 15 percent and thus a viable alternative investment, Canelo said. That can hardly be said for the 30-year Treasury bond now, which is currently yielding well below 7 percent, Canelo said.

Another provision of the package would allow investors who earn $150,000 or less to make tax-free withdrawals from IRAs to purchase a house for the first time, or for college expenses.

John Michel, a marketing director at Merrill Lynch, said this added flexibility would give financial planners more ammunition to sell retirement savings plans to younger investors. He pointed out that 401(k) plans that allow tax-free withdrawals generally attract more contributions than those that don’t, “because people know they can get it out.”

But while investors contribute more to funds that offer such options, Merrill research has shown that they tend not to exercise them. “The interesting thing is that the people don’t take it out.”

The plan also calls for a $400-per-child tax credit beginning next year that rises to $500 in 1999, for children 16 and under. Employers could adjust withholding at the beginning of next year, which would increase employees’ take-home pay.

But investors are not inclined to invest those extra few dollars a month in stocks, said William Dodge, portfolio manager at Marvin & Palmer Associates Inc. of Wilmington, Del. The families most affected by this credit, those earning $75,000 or less per year, are less likely to save than to spend, he said.

Instead, the extra money will likely be spent on discretionary items like clothing, or to leverage big-ticket items like household appliances. As such, it will prove an extra shot of adrenaline to an already robust economy.

The child credit is “very likely to help retail sales and may provide marginal benefit to retail stocks,” Dodge said.

Charles White, portfolio manager at Avatar Associates in New York, agreed that “it never hurts to have more money in your pocket.” But the long-term effect of the budget pact, especially the capital-gains tax cut, will be felt less at the shopping mall than at the stock exchange, he said.

When investors can pay less taxes on capital gains than on ordinary income, they are more inclined to buy stocks over bonds, White said. Within the stock market, they are more apt to favor growth shares, like technology stocks, over steady dividend earners, like utilities, White added.