How Will Tax Increases Impact the Markets?

June 24, 2021

It’s no secret that taxes are expected to rise. The Biden Administration has proposed higher taxes on individuals and businesses, potentially reversing many of the effects of the 2017 tax cuts.

The proposals and what becomes law, however, are two different things. With a narrowly divided Congress, it seems unlikely the proposals will pass as is. A tax hike in some form, however, appears likely, and high-income taxpayers and corporations will likely bear the brunt of the cost.

What does this mean for the economy and, ultimately, the markets? This is not the first time we have faced a situation of rising taxes and ongoing uncertainty. What does history suggest?

Marginal Tax Rates:

The marginal tax rate is the rate taxpayers pay on their last dollar of income. In 2017, the highest rate became 37%, a slight decrease from prior levels. President Biden is proposing going back to that top marginal tax rate of 39.6%.

When you look at history, this is still relatively low. The top marginal rates have been much higher, especially during wartime. And don’t forget, the top rate jumped from 35% to 39.6% as recently as 2012. The Patient Protection and Affordable Care Act added an additional 3.8% to this, making the maximum rate 43.4%.

It didn’t faze the markets, however. The S&P 500 was up 16% that year and 32% the following year (1). 

Corporate Tax Rates:

The enacted tax reform plan lowered the corporate tax rate to 21%, below the OECD (2) average of 22%. However, corporate taxes are expected to increase towards 28% to fund programs such as infrastructure. Even at 28%, this rate is still considerably lower than historical levels in the US:

Profits ultimately drive stock prices, but will this de-rail earnings? It can certainly be a headwind, but how much of a headwind ultimately depends on the vibrancy of the economy, which can offset it. A re-investment in infrastructure could boost the economy and reduce some of that drag.

How have the markets performed during years of corporate tax rate increases? Going back to 1950, corporate rates have increased five times, and the average return for the S&P 500 during those years was 19% (3).

Capital Gains

President Biden looks to increase the top capital gains rate to the top marginal rate of 39.6% for taxpayers with over $1 million of income. This, alongside the Net Investment Income tax of 3.8%, would bring the top rate to 43.4%.

Increased capital gains rates have occurred approximately a dozen times since the Great Depression. Of those years, the S&P was negative only twice the year the increase occurred (1934 and 1969). Both of those years had major overarching events, with the Great Depression and Vietnam War in full bloom, respectively. (4) Again, there seems to be little correlation to capital gains rates and the markets.

This re-iterates the importance of strategies such as tax-loss harvesting, which can enhance after-tax performance. Unused tax losses can offset capital gains and be carried forward to offset future gains you would otherwise pay tax on.

Summary:

Historically the US stock market has performed well even during years of tax increases, whether they were personal, corporate, or capital gains. Over time, investors have been rewarded for the risks and staying invested in various tax environments. Maintaining a long-term focus has proven time-and-time again to be the best approach.

That said, everyone is different, and it all comes down to what is right for you. Now is a good time to connect with your team and re-evaluate where you are at to ensure your mix aligns with accomplishing your full life now and in the future.


Disclosures:
1. Source: Y Charts
2. Source: Dimensional Fund Advisors
3. The Organization for Economic Co-operation and Development is an international group of 38-member countries that works to build better polices for better lives (source: OECD.org).
4. Source: Dimensional Fund Advisors and U.S. Treasury.

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