Taxes & the Market Crash
Jude Wanniski
April 17, 2000


To: Alan Abelson, Barron's
From: Jude Wanniski
Re: Tax Selling

As the dean of financial writers, Alan, I think you will appreciate the argument I've been making since mid-March about the NASDAQ selloff. There have been a host of reasons offered -- Microsoft, Alan Greenspan, "bubble" theories, and threats of Internet taxation. Each of these offerings has some validity, but I don't think any fit as simply and cleanly as the thesis that the folks who made a killing on capital gains in 1999 waited too long to sell in order to cover their tax liabilities before the April 15 deadline. I began warning my clients about this phenomenon on March 30 when no other explanation made sense to me -- and I realized there had never before been such dramatic gains in a single year in leading-edge equities as there were in 1999. Without a precedent, investors had to learn the hard way that when they all hold onto their rocketing stocks, figuring they will sell a few at the last minute to satisfy IRS, they will find themselves in a crush at the one exit door. Here is a memo I sent out on Saturday to a number of political newsies, with the backup memos I sent my clients as April 15 approached. If I'm right, the hi-tech market should now be at or very close to a bottom.

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Memo to political writers.... April 15, 2000
Political writers should be aware of the implications of the sell off on Wall Street. Polyconomics began warning clients on March 30 that the weakness on NASDAQ could be attributed to selling to meet big tax liabilities on the capital gains of 1999. The NYT is well aware of my arguments but in today's lead editorial says we should not try to attribute any single reason for the sell off, but that the candidates for the presidency should not even think about cutting taxes, as there will be a decline in tax revenues because of the sell off. Hmmmm. Here are the bits and pieces we have been sending out on the topic. Reporters can use any or all of these briefs:

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MARCH 30 "Brief": There must always be at least one reason for a sharp market sell-off or a sharp market surge. The NASDAQ sell-off has me thinking of a connection to April 15 and the fact that there is no withholding on capital gains. There was a sell-off last year too, remember, with a bounce back after April 15 and a flat market for some months thereafter. In other words, people who took capgains before December 31 now find they owe Uncle Sam and must sell equities for that purpose. As they see the market slide, they know they better sell sooner than April 15 or wind up having to take deeper losses this year. The funds are not lost to the economy, but they might as well be, as Treasury takes the receipts from NASDAQ sales and uses them to pay down the national debt. A poor use of capital. (JW)

APRIL 12 "Brief"  On my short vacation in Louisiana, I of course noticed the action in the NASDAQ, but there was nothing I could think of that would offer a better explanation than the March 30 Brief -- which I send here along with a NYPost business story that ran Tuesday, the 11th. There are many risks facing the dot.coms, but none as palpable as the April 15 deadline for paying taxes on 1999 income. The market cannot discount in advance for the myriad decisions individual taxpayers will make in selling shares to meet tax liabilities -- because the market has no way of knowing who cashed in on what shares last fall. In other words, there is no "efficient market" in the short run in determining the behavior of investors -- as opposed to the value of the shares in the broad marketplace. The Post article points out that there were market sell-offs last year on the three Mondays PRIOR to April 15 and advances on the three Mondays AFTER the tax date. With Y2K cautionary selling in the last quarter of 1999, the effect would be greater this year, as taxpayers are discovering they have to liquidate now for gains they took then. And the shares being sold tend to be those that had the sharpest increases this year. If there is not some darker problem we do not see, the bounce-back should take place in pieces, beginning later in the month, as tax refunds go into the shares driven down and in a sense undervalued by this tax effect. Of course, some enterprises that have been starved for cash in the runoff may never recover, while others coming onstream will start fresh. Here is the Post piece:

By Beth Piskora April 11 New York Post

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APRIL 14 "Brief": I'd been tempted all day long to write this brief but decided to wait until the market had closed. If I had been wrong in my March 30 hypothesis that the market was selling off because of millions of Americans scrambling to pay tax liabilities on their huge 1999 capital gains, today would have been a nothing day. My net worth is down considerably since March 30, if it is any consolation. I don't manage any of my own money. And until I saw the mad rush this week culminating in today's carnage, I could not be sure I was right. There is now no doubt in my mind that this sell-off has been almost entirely a result of the tax consequences of 1999 -- which means we've hit bottom, as there is no way taxpayers can sell stock on Monday to meet 1999 liabilities, even with extensions on filing.

This situation has never confronted the stock market.... ever -- which is why it is such a surprise to the world. In earlier periods of history, where there have been paradigm shifts from Old Economy to New Economy, tax rates were much lower. The transition from brick-and-mortar enterprise to a street-of-dreams was also extended over several taxable years. The folks who were cashing in last year on their gains, to buy this or that or pay estimated quarterlies, of course believed they would be able to sell off a little of this and a little of that in March and April to meet their tax liabilities. It is human nature. The market can't discount this kind of behavior. We now will see the really topnotch analysts discover the hidden state and local tax glitches that compounded the problem -- as in many states people are finding their state liabilities exceed their federal, because of state piggybacking on federal returns, except of capital gains.

If I were managing my own money, folks, I would jump in on Monday. The pattern should follow 1999's when the bottom was hit on April 16 and jumped from there when mass selling pressure was removed. How fast will recovery occur from these lows? That depends on our political class, and how they interpret the events of the last few weeks. If my hypothesis is brushed aside and the wise guys decide it was Greenspan threatening to ratchet up the funds rate, the debate will go on and on about whether the Fed should do this or that. Much better, if our "leaders" understand the noxious effects of capgains taxation and the threat to the Internet of taxation of any kind in the next few years. The talk shows will be most interesting on the weekend. I'll try to watch all of them and report on Monday.

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PS: Taxpayers still have Monday to sell in time to include checks in their returns to the IRS without suffering major penalties.