The Internal Revenue Service, tax planners and filers are getting ready for the start of the 2023 tax season which kicks off 23 January. Taxpayers will need to submit their paperwork and pay any taxes owed by 18 April. The tax season doesn’t just stir people to sort out their financial papers, it also causes gyrations in the stock markets.
As Tax Day approaches a common phenomenon occurs with the price of stocks slumping towards the end of the tax season. While the dip doesn’t typically last that long, usually markets rebound by mid-April, the reason, or theory, behind it is fairly straight forward.
Another anomaly has been seen at the end and beginning of the year. Known as the ‘January Effect’, the value of stocks drop in December and then rebound in January. This one however has all but disappeared over time, some even doubt that it exists, and again the explanation is partially tied to taxes.
What explains the dip?
Simply put: investors are withdrawing money to pay for their taxes, in all likelihood.
Data research group Kensho analyzed various financial sectors since the year 2000, and found that in the first two weeks of April, when the first people will begin paying their tax, the S&P 500 was down an average of 0.2 percent. However, just two weeks later, it was up 1.7 percent on average.
Sectors with the biggest positive swing between the two weeks are: technology (3 percent swing), industrials (2.2 percent swing) and financials (1.7 percent swing). With such assured decreases and increases, the common denominator is the repayment of taxes.
The January Effect
First noticed in 1942 by investment banker Sidney Wachtel, the ‘January Effect’ is noticed more in small cap stocks outperform the overall market in the first month of the year. The effect is hypothesized to come from two events that take place in December.
As the end of the fiscal year approaches, investors seek to take advantage of dips in market values for the purpose of tax-loss harvesting which can be used to offset any realized capital gains. This in turn sparks a selloff in the stock market. December also sees investors receiving year-end cash bonuses which they use the following month to purchase investments creating a rally in January.
However, over time this effect has become less pronounced as it has become more widely known. Furthermore, the gains that could be earned are so small that when transaction costs are calculated in they essentially make it unprofitable.
How do taxes on stocks work?
Taxes on stocks fall into the category of capital gains.
A capital gain is any money made on an investment, cryptocurrency or otherwise. For example, if you made a $100 investment, and you cashed out once it grew to $110, the capital gain would be $10. There is no capital gain until an asset is sold, which is a loophole the super-rich use to payoff loans without having to pay income tax.
Capital gains are taxed in two ways depending on how long you hold onto an investment, with short-term capital gains from investments being normally higher than longer-term capital gains. To prevent investors from abusing tax-loss harvesting the IRS has rules disallowing wash-sale losses.