Wednesday, November 5, 2008

Why Raising Capital Gains Tax Can Crash The Market

It seems to me that you do not have to be a Harvard Economist to understand why raising the Capital Gains tax can cause an economic crash. Yet a surprising number of people that I come across disagree. After working through my simple logic problem though, they seem to come around. So hear it is; and please feel free to try and dispute it or tell me where I am going wrong in the comment section.

You have $1,000,000 in the market. Right now the Capital Gains tax is 15%. That means that if you take out that money out of the market right now the government would take $150,000 leaving you with $850,000. The Capital Gains tax will be raised tomorrow to 20%. That means that if you take you money out of the market 48 hours later the government would take $200,000 leaving you with $800,000. So, by staying in the market for an extra two days you lose $50,000. What do you do; sell. Now, what is the effect of everyone in the market selling all at once; market crash? Worse yet, people have an incentive to sell first. If you wait to long before selling, the market will have already gone down and take with it the value of your investment.

$50,000 may not sound like a lot of money to some as a reason to pull out of the market, but that assumes the person "only" has $1,000,000 in the market. It also takes for granted that the market will not crash from other people trying to avoid the tax increase. Keep in mind, some people have more than $1,000,000,000 in the market; you do the math on that loss. Worse yet, this assumes a 5% increase. What if some are right that a %10 to %15 increase may be in the works?

The fear of this happening can cause it to happen, even if that fear is later seen to be irrational.

There it is; poke holes in it if you would like.

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