Tax Policy Has Changed Who Owns Stocks
STANFORD GRADUATE SCHOOL OF BUSINESS—Since World War II, financial institutions have come to own a far greater proportion of stocks than private households have. Just after the war, individual citizens owned 90% of the stock market; by 2006, they owned only 30%. And the trend is not restricted just to the United States. It spans the globe.
Why the big drop? Most research has assumed that intermediaries like the mutual fund industry have taken over stock ownership due to a public demand for portfolio diversification. But a new study from Stanford argues that tax policy is the driving force. The research shows that household stock ownership decreases as the tax benefits associated with owning stocks inside a pension plan increase.
The finding sheds new light on the long-term effects of taxation on corporate finance and asset prices, and should be of interest to public policy makers.
"The particular tax policies that have influenced stock ownership are those that on the one hand have increased households' income tax, and on the other have created the possibility for pre-tax savings," says Ilya Strebulaev, associate professor of finance and Spence Faculty Scholar for 2010-2011, a coauthor of the study. Such policies, he notes, are fairly recent, having originated only in the 1930s in the United States.
"When income taxes are high, households prefer to save within their tax-deferred retirement plans," he explained. Because of increased taxes, over the past 60 years individuals have transferred more and more of their direct stock ownership to various financial intermediaries, such as pension funds in the United States and insurance companies in other countries, he says.
Using empirical data, Strebulaev and his coauthors, Kristian Rydqvist and Joshua Spizman of Binghamton University in New York, made the dramatic discovery that up to 70% of all stocks in the United States - held by domestic agents such as mutual funds, pension funds, and insurance companies - are now kept in tax-deferred plans.
The researchers also looked internationally, painstakingly collecting information from countries such as France, the U.K., Japan, Sweden, Germany, Canada, and Finland. Their multicountry empirical analysis revealed the patterns over time quite clearly. "We see the evolution of stock ownership from individuals to intermediaries in many countries, and this trend does match their variations in tax policies," says Strebulaev.
The paper also explains another important phenomenon: the creation of the mutual fund industry. The researchers discovered that as late as 1980, the mutual fund industry in the United States owned less than 4% of all stocks in the nation — which comes as a big surprise. Today, they are major owners of stocks.
Most observers assume the industry grew to address people's need to diversify their portfolios. "We show, however, that in various countries, mutual funds took off only when the 'defined-benefit' retirement plans were replaced with 'defined-contribution' plans — which allow people to choose their own providers," Strebulaev says.
Defined-contribution plans — 401(k)s — were introduced in 1982. Private pension plans were quickly converted into mutual funds, and this is why we see the growth of this industry, explain the authors.
"Nobody looks at this data, even though it's publicly available," says Strebulaev. "The same phenomenon happened in other countries as soon as retirement contribution plans were instituted. In countries where retirement contribution funds did not get instated, mutual funds never took off."
The paper thus has enormous implications for tax policy, and how and where it does —and doesn't — have an impact on people's stock purchasing behavior. "It's unlikely that changes in capital gains taxes had any significant impact on stock values, portfolio decisions, and economic growth, for example," says Strebulaev, referring to an old debate regarding the influence of such taxes established by the Bush Administration. "Because a substantial fraction of stocks is held in tax-deferred plans, any temporary changes in tax policy are not likely to affect either people's decisions to trade stocks or stock prices."
The study's findings are not confined to stocks; the same changes happened in bond markets. "Because there are both taxable and tax-exempt bonds, the bond market provides an even better test of our explanation," notes Strebulaev.
The fact that diversification may not be the primary factor in explaining the proliferation of financial intermediaries may also provoke questions about the true role of such institutions in the economy. Finally, the findings of the paper suggest that academic research conducted over the past few decades on the long-term effects of taxation on corporate finance and asset prices may need to be reevaluated.