This article on CFO.com is a good example of the distortions and dislocations that follow in the wake of harmful tax changes. Ideally, business owners sell assets when someone else can make better use of them, and/or when they can make better use of the monetized value (eg, by investing in projects that offer a higher return on capital). This is how markets work to optimize the allocation of capital in an economy. Allowing capital gains tax rates to rise, even by a seemingly small 5-10%, raises an owner’s future required returns by several magnitudes.
Although the national elections are still more than a year away…there have been rumblings in Congress to raise the tax rate on long-term capital gains for corporations and higher-tax bracket individuals from the current 15 percent to 20 or 25 percent.
If that happens, some owners of smaller businesses may want to dispose of their companies before a hike in the capital gains rate eats into deal proceeds…A recent analysis by CMF shows that if the capital gains rate rose to 25 percent in 2009, a business owner would have to generate 24 percent more value in his company over the next two years to match the after-tax value of the company if it was sold today under the 15 percent rate…"…additional capital gains taxes and…foregone investment income provide a strong incentive to sell your business today if you believe that tax rates will be increasing in the future."
If capital gains rates rise, and the real federal funds rate remains relatively unchanged, a recession could be in the cards some time after 2008. If there’s a silver lining, that could be supportive of the U.S. dollar…although one might ask the Japanese if they would have traded their long recession and bear market for a weaker Yen…