Does tax season affect the stock market?

The 2024 tax season will begin on January 29th, and the Internal Revenue Service, along with tax planners and filers, are preparing for it. Taxpayers have until April 15th to complete their paperwork and pay any taxes owed. Apart from prompting people to organize their financial documents, the tax season also has an impact on the stock markets.

As tax season begins, it is common to observe a drop in stock prices towards throughout the period. Although the dip is usually short-lived, with the markets recovering by mid-April, the theory behind it is relatively straightforward.

Another phenomenon observed is the “January Effect,” where stock prices decrease in December and recover in January. However, this effect has largely disappeared over time, with some doubting its existence. Again, this phenomenon is partially linked to taxes.

What explains the dip?

Investors are likely withdrawing money to pay for their taxes, according to data research group Kensho. They analyzed various financial sectors since 2000 and found that during the first two weeks of April when the first people start paying their taxes, the S&P 500 typically decreases by an average of 0.2%. However, just two weeks later, it increased by an average of 1.7%. The sectors that experienced the biggest positive swing during this time are technology (3% swing), industrials (2.2% swing), and financials (1.7% swing). The common denominator for these fluctuations is the repayment of taxes.

The January Effect

The ‘January Effect’ was first discovered in 1942 by investment banker Sidney Wachtel. It is observed that small-cap stocks tend to perform better than the overall market in the first month of the year. This effect is thought to occur due to two events that take place in December.

As the fiscal year-end approaches, investors look to benefit from dips in market values for tax-loss harvesting, which can be used to offset any realized capital gains. This prompts a selloff in the stock market. Additionally, investors receive year-end cash bonuses in December, which they use to buy investments in the following month, resulting in a rally in January.

However, as time passed, this effect became less noticeable as it became more widely known. Moreover, the gains that could be earned are so minimal that when transaction costs are factored in, they make it essentially unprofitable. This year, the stock market has made gains in January, contrary to the trend noticed by Wachtel.

How do taxes on stocks work?

Capital gains taxes are applied to stocks. Capital gains refer to any profit earned from an investment, including cryptocurrency. As an example, if you invested $100 and cashed out at $110, your capital gain would be $10. Capital gains are only realized when an asset is sold, which is a loophole used by wealthy individuals to pay off loans without incurring income tax.

The tax on capital gains is based on how long you hold onto the investment, with short-term gains typically taxed at a higher rate than long-term gains. The IRS has implemented rules to prevent investors from abusing tax-loss harvesting, including disallowing wash-sale losses.