The Nikkei 225 fell 2.3 percent today, is down 3.5 percent since last Tuesday and 6.8 percent since October 23rd. The cause for drop is being attributed to an anticipated government report which will recommend allowing lower tax rates on capital gains and dividends expire. These provisions will not expire until 2008 yet markets are dropping in response to this change.

The U.S. is faced with a similar situation. Both Japan and the U.S. initiated lower tax rates on dividends and capital gains in 2003 to inject adrenaline into slumping equity markets. The lower tax rates increased the after tax rate of return on equities, making stocks more attractive to other financial instruments, all else being equal. Take away the lower rates and you lower the after tax rate of return and stocks will fall as evidenced by what is happening in Japan this past week.

The U.S. extended the lower rates on capital gains and dividends earlier this year from 2008 to 2010. We were told at the time it was unnecessary to renew these provisions since they were not expiring for another two years, but the experience of Japan shows just how important this initiative was.

Nearly every Democrat voted against the provision in 2003 and again in 2006. There is a real threat that a Democratic Congress will vote to repeal this measure, most likely as part of "tax reform," but we doubt President Bush will let this pass since the 2003 tax cut is the crown jewel of his administration. However, in 2008 all bets are off the table and the U.S. may face a situation to exactly what is happening in Japan right now.