The proposal is expected to be formally unveiled next week during the president's address to Congress, but equity markets have already communicated their displeasure.
Biden's proposal breaks new ground in terms of the taxation of investment income, which traditionally has received more favorable treatment than ordinary income. However, as CIO has discussed in prior reports, the president's proposal is subject to revision after negotiations with Congress. We expect those negotiations to conclude with a lower rate than the one now proposed. The capital gains tax rate is likely to rise for individuals with higher incomes, but our base case envisions a rate of 28% ( read our recent POTUS 46 report for more).
What is the market impact?
While we can't rule out some additional modest equity market volatility as investors react to this proposal, we think it will be very short-lived. Some investors may choose to harvest capital gains now, rather than potentially pay a higher rate in the future (more about that later). However, 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.
History shows there is no relationship between changes in capital gains tax rates and the performance of the US stock market. For example, the last time capital gains taxes went up was in 2013, when they rose 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.
How could higher capital gains taxes affect my portfolio?
If Congress raises the capital gains tax rate this year, the higher rate could apply to sales that occurred in 2021 (including sales that occurred before the law was passed). Even so, because of how capital gains taxes are calculated, investors will still retain significant control over when you pay taxes. It is often possible to earn a handsome return on your investment account, but avoid paying any capital gains taxes in the following year because you didn't realize a net capital gain.
By deferring taxes into the future, even if you eventually pay a higher tax rate, more of your wealth will be growing in your investment account rather than going to the IRS. When you eventually do sell, you may pay more in taxes and also have more after-tax wealth because of compounding growth in the interim.
Many families will not be subject to the higher capital gains tax that's being proposed. If you are able to defer your capital gains taxes to years where your taxable income is below the proposed USD 1 million threshold, it may be possible to continue paying the current long-term capital gains tax rate of 23.8%.
If you do have a high level of taxable income, you may be able to work with your financial and tax advisors to reduce it below the USD 1 million level, for example by allocating more to municipal bonds (whose income is tax-free at the federal level) rather than corporate bonds; by deducting some of your income via charitable contributions; or by receiving dividend income instead of a salary from your business interests.
Capital gains tax rates are not the only tax increase that has been proposed by the Biden administration. We expect to learn details regarding proposed changes to the estate tax, including altering the provisions regarding the "step-up" in cost basis and the lifetime gift tax exemption, next week. We are obliged to remind readers that many of these details will be subject to contentious negotiations in Congress and are likely to change over the course of the next few months.
Our report, 2021 UBS Wealth Way strategy guide: Managing taxes and giving to others, provides some strategies that investors can take today to achieve their goals in the face of these and other potential tax increases.
Main contributors: Solita Marcelli, Thomas McLoughlin, Justin Waring, David Lefkowitz
Content is a product of the Chief Investment Office (CIO).
For more, see POTUS 46: Markets react to Biden tax proposal, 23 April, 2021.
Tax disclaimer: UBS Financial Services Inc., its affiliates and its employees are not in the business of providing tax or legal advice. Clients should seek advice based on their particular circumstances from an independent tax or legal advisor.
UBS Wealth Way disclaimer: UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Switzerland AG, UBS AG and UBS Financial Services Inc. and our advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment. Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability.