The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Apr. 24, 1997)

In a recent column, I inadvertently started a small brush-fire with my comments about the possibility of a cut in the capital gains tax, and how it was likely to be only for long-term capital gains.

My concern in writing the piece was less a policy concern than it was a strategic planning one. We could debate taxation policy for years, of course, and never achieve a plan everyone felt was equitable and feasible.

Working from the assumption, however, that anyone reading this is an investor, I feel it's important to discuss the possible implications of such a tax rate change. Today, we have federal tax brackets ranging from 15% to 39.6%, and all short-term capital gains are simply taxed at one's ordinary income tax rate.

Long-term gains, however, receive a slight break in that the maximum rate one will pay on them in 28%. An investor in the 31% - 39.6% brackets has to consider the gap in tax rates between that 28% ceiling for long-term gains and the potentially higher rates for short-term gains.

For example, if one is contemplating after-tax returns, the Dow Approach (with a 23% pre-tax return) would generate an after-tax return of 16.5%. An investor in the highest bracket would have to achieve a short-term pre-tax return of 27.3% to come away with the same after-tax return. So there's a sizable difference involved. (4.3% may not seem like much until you compound it for a couple of decades; then it looms very large, indeed.)

If the long-term maximum rate is cut to 15%, for example, that gap becomes even more pronounced. The historical Dow Approach pre-tax gain of 23% becomes 19.55% after taxes. To get that rate at a 39.6% short-term tax rate suddenly requires a pre-tax return of 32.37%. And we're not even considering the higher trading costs and spreads of more aggressive trading strategies.

My original thought, then, as I wandered down this road a while back, isn't what the government should do (although I obviously have my own opinions, as do you). But rather, I'm more concerned with how such a possible gap in the long-term and short-term capital gains tax rates will affect our strategies.

It obviously makes my desire to find a better long-term mousetrap even more pressing than to refine the monthly or quarterly trading models we follow so carefully in the Workshop. If we can find a long-term approach that generates gains in the mid- to upper-twenty-percent range, it'll be pretty hard to beat under the potential new tax structure. Keep it in mind.

Monthly Growth Screens
(Jan. 3 to present)
  9.46%  Relative Strength  
  3.09%  S&P 500 Index  
 -1.24%  Low Price/Sales  
-10.04%  YPEG Potential  
-13.36%  Investing for Growth  
-21.60%  Unemotional Growth  
-21.77%  EPS Plus RS  
-28.27%  Formula 90  

Annual Value Screens
(Jan. 1 to present)
 6.38%  Dogs of the Dow  
 5.33%  Dow Jones Ind Avg  
 2.94%  Beating the S&P  
-2.73%  Unemotional Value  
-2.73%  Beating the Dow  
-3.81%  Dow Combo  
-8.70%  Foolish Four