If all goes according to expectations, next year the federal tax rate on capital gains will rise for the first time in 23 years from 15% to 20%. Though the past isn't always a distant mirror, it's worth taking a walk back in time to 1986 and revisit what happened in that era.
Things were different in those days. The New York Mets won the World Series in 1986. Ronald Reagan was president and Congress, led by Bill Bradley and Jack Kemp, radically overhauled the federal tax code. The highest marginal rate on income was slashed from 50% to 28%. There were two rates on income, 15% and 28%, the closest this nation has come to a flat tax in modern times. As part of the bargain, many loopholes were eliminated (bye, bye limited partnerships), deductions like credit card interest were abolished and the maximum rate on capital gains was increased from 20% to 28%.
It was the age of the corporate raider and folks like T. Boone Pickens. Carl Icahn and Ronald Perelman were making the CEOs of America's biggest companies quake in their stretch limos. With a huge assist from Drexel Burnham Lambert's junk bond department in Beverly Hills, these characters were putting companies into play on a weekly basis. The rest of Wall Street was frantically scrambling to clone Drexel's incredible profit machine and struggling to create their junk bond units to finance LBOs.
How vast were these profits? After Drexel's junk bond maven, Mike Milken, was indicted in late 1988, U.S. Attorney Rudy Giuliani leaked the skinny on Milken's 1986 income of $500 million, prompting even well-heeled Drexel partners to drop their jaws.
When the 1986 tax act became law, these raiders sensed opportunity and took off on a bender that would last for more than two years. Shareholder value was their mantra. Almost every day, they would tee up companies and demand that their boards work over time to quickly complete the deal to give shareholders the full advantage of the soon-to-expire 20% capital gains tax rate. In actuality, most raiders were hoping that a bigger corporation, or so-called white knight, would swoop in and trump their offers.
Did the expiration of the 20% capital gains tax rate in January 1987 hurt stock prices? Hardly. From January to September, equities went crazy. Propelled perhaps by the big cut in income tax rates, the Dow climbed from 1,897 to over 2,700 on August 25 in a frenzy that looked like a runaway train going down Mt. Everest.
Stock prices careened upwards at a faster rate than Giuliani could arrest and indict Wall Street's legion of inside information traders. By then, he was getting lots of help from his new chief assistant, the crooning Ivan Boesky.
Fed chairman Paul Volcker discerned the all-too-obvious symptoms of an overheating economy and decided he'd had enough of all this nonsense. In April, he jacked up interest rates dramatically, triggering a $100 billion bath for bondholders around the globe.
Merrill Lynch alone lost an estimated $400 million in mortgage-backed securities, and the firm fired the trader, Howie Rubin, whom it deemed most responsible for the fiasco. Rubin's post-Merrill punishment? A few weeks later he was hired by Bear Stearns.
Equity markets showed little sympathy for the woes in bonds. The party rocked on, with the major indexes sporting 40% plus gains by late summer.