How To Avoid Another Stock Bubble

At the peak of stock market in the spring of 2000, the value of all publicly traded U. S. stocks totaled an incredible $16 trillion. At that time, the gross domestic product was about $10 trillion, so stock values were 160 percent of GDP. Never before had the value of stocks exceeded the GDP. At two previous peaks, in 1929 and 1987, stock valuation reached about 80 percent of GDP, and you know how the market dropped from those lofty levels.

Stock gains were changing our society. Companies used their stock value to acquire other companies; corporate officers got rich from their stock options; board of directors were elated with their companies’ progress, auditors were pressured to make the books look as attractive as possible to increase stock values, and workers enjoyed reading their quarterly 401(k) retirement valuation. Federal and state governments were also pleased with the increased revenues they gained from the enormous increase in receipts from capital gains taxes.

Looking back, we should have known it was too good to be true. Employees were quitting their boring daytime occupations to join the burgeoning ecstatic ranks of “day traders” making an easy living by trading stocks. Amazon chairman Jeff Bezos’ mug was on the cover of TIME magazine as man of the year and brick-and-mortar bookstores worried they would be put out of business. The owners of the NASDAQ stock exchange were planning to sell shares in their most profitable enterprise to the public as their index passed 5,000. James Glassman pulled in the royalties from his book, which suggested the Dow Jones Industrial Average could reach a level of 36,000. Right at the market peak, the stock of Cisco corporation was valued higher than long-time-first-place General Electric’s $500 billion market value, and a California newspaper chirped that Cisco could become the first $1 trillion company in history. (Cisco has since dropped to the fifteenth position.)

Japan’s bubble in the previous decade looked just as rosy. In 1989, the value of all stocks traded in Japan exceeded the value of all US traded stocks as the Nikkei average approached 40,000. Also, the value of real estate in Tokyo was being measured in inches rather than hectares. Their bubble broke and they have been in a downspin for the past twelve years as the Nikkei has deflated to under 10,000. (The percentage drop in the NASDAQ index over a 2.5-year period almost exactly mirrors the Nikkei drop over a twelve year period.)

Now that US stock values have dropped from $16 trillion to $10 trillion, everyone is looking for scapegoats. Instead of the old-fashioned “caveat emptor” (let the buyer beware), we have congressmen ringing their hands and running in circles to find remedies so “this won’t happen again.” Let’s see, who can we blame today: aggressive accounting firms; corporate leaders who failed math in elementary school but got an MBA anyway; the lax Securities and Exchange Commission that looked the other way; investment banking companies that rewarded their best corporate clients with favorable ratings and scarce IPO stocks?

While all of these bear some guilt, we suggest that Congress fess up to having helped create the bubble through an unfair and imbalanced tax system. Capital gains are taxed at 20 percent while dividends are taxed as high as 60 percent (first corporate income is taxed at thirty percent, and then, when some of the remaining income is distributed to shareholders as dividends, it is taxed as high as 40 percent).

No wonder the average dividend yield on the Dow Jones Industrial stocks has plummeted from 6 percent in 1982 to only 2 percent now. Why would anyone in their right mind want to receive dividends when they can earn capital gains, which are taxed at half the level? Corporations respond to this perceived difference by using earnings to repurchase their own stock in order to increase stock price, rather than pay dividends unwanted by stockholders, officers, directors, etc., because of the adverse tax consequences.

Similarly, interest paid on checking and banking accounts, on money market mutual funds, on bonds, and on mortgages is taxed at “ordinary” tax rates that can be as high as 40 percent. Is it any wonder that over the past few years the national savings rate has dropped to zero? Not only have interest rates dropped to 2 percent, but also the federal government takes up to 40 percent of that paltry yield.

Congress contributed greatly to the stock market bubble through the distorted incentives created by the tax code. Earlier this month, Rep. Chris Cox (R-Calif.) introduced a bill that would do away with the double taxation of dividends. Elimination of the double taxation of dividends and a generous tax credit for dividends and interest would go a long way toward restoring the good name of capitalism. That would also assist the millions of modest-income families and individuals who never had enough capital to get into the stock market to benefit from the favorable capital gains tax rates.