Thought of the day
The S&P 500 fell 0.9% on Thursday following news that President Joe Biden will propose raising capital gains taxes on individuals earning more than USD 1mn. Media reports suggest that the top tax rate for such high earners would increase to 43.4%, including a 3.8% tax on net investment income, up from 23.8% at present.
The proposed tax increase also comes at a time when US stocks are only around 1% below an all-time high. With a lot of good news already priced into markets, stocks could be vulnerable to negative surprises, whether from growth disappointments, higher inflation, or policy missteps. As a result, the plan could contribute to pockets of volatility ahead.
But we still see upside for markets, and we don’t expect the Biden tax proposals to be a major headwind for stocks for the following reasons:
- Congress is likely to opt for a more modest tax hike than the president is suggesting. Our base case is for the top rate to increase to 28%, with lawmakers pushing back at the near doubling suggested by the administration. This would likely limit the downside for markets. We also expect Congress to approve a smaller increase in corporation taxes than the one suggested by President Biden.
- Historically, increases in capital gains taxes have not harmed stock performance. For example, the last time capital gains taxes went up was in 2013, when they jumped by nearly 9 percentage points. Yet stocks rose 30% that year. In addition, we find no correlation between capital gains tax rates and equity market valuations. Price-to-earnings multiples have been as low as 10x when the capital gains tax rate was 20%, and as high as 18x when it was 35%. Ultimately, other factors such as the outlook for economic growth, monetary policy, and interest rates are much more powerful drivers of equity market returns and valuations.
- Not all US investors will be affected by the rate increase. US taxable domestic investors own only about 25% of the US stock market. The other 75% of the market is owned in accounts that aren’t subject to capital gains taxes (e.g., retirement accounts, endowments, foreign investors). We would expect opportunistic investors who are unaffected by this proposal to step in and take advantage of lower prices. In addition, US taxpayers who may be affected by the plan can consider various strategies, such as harvesting capital gains ahead of any changes, or deferring stock sales until earnings fall below USD 1mn.
After a period of very strong investment returns, we think investors should expect pockets of market volatility ahead. Investors can consider how volatility may help them diversify, enhance yield, or get exposure to markets in a more defensive way. Click here for more on such strategies. However, we think the impact of higher capital gains taxes is likely to be contained, and we continue to see upside potential for equities, especially in parts of the market exposed to a broadening economic recovery. Click here for more on positioning for reflation.
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