“Let me tell you how it will be; there’s one for you, nineteen for me.” —The Beatles
The U.S. stock market can perform well even when U.S. corporate taxes rise. I’ll get to that in a moment, but let’s not bury the lead. Increasing corporate tax rates feels like old news compared to President Biden’s newly released details on paying for his proposed American Families Plan.
The White House proposes nearly doubling the capital gains tax rate from 23.8% to 43.4% (including an existing 3.8% surtax) for people earning more than $1 million per year. That would be higher than the current highest federal income tax bracket, which is 37%. The American Families Plan allocates hundreds of billions of dollars to the administration’s domestic priorities, such as:
- $225 billion toward high-quality child-care and ensuring families pay only a portion of their income toward child-care services, based on a sliding scale
- $225 billion to create a national comprehensive paid family and medical leave program
- $200 billion for free universal preschool for all 3- and 4-year-olds, offered through a national partnership with states
- $109 billion toward ensuring two years of free community college for all students
- About $85 billion toward Pell Grants, and increasing the maximum award by about $1,400 for low-income students
- A $62 billion grant program to increase college retention and completion rates
- A $39 billion program for two years of subsidized tuition for students from families earning less than $125,000 enrolled in a four-year historically Black college or university (HBCU), tribal college or university, or minority-serving institution
- $45 billion toward meeting child nutritional needs, including expanding access to the Supplemental Nutrition Assistance Program (SNAP)
- $200 billion to make permanent the $1.9 trillion COVID stimulus plan’s provision lowering health insurance premiums for those who buy coverage independently
- Extending through 2025, and making permanently fully refundable, the child tax credit expansion included in the COVID relief bill
- Making permanent the recent expansion of the child and dependent care tax credit
- Making permanent the earned income tax credit for childless workers
The stock market is politics-agnostic, so, not surprisingly, the stock market dropped on the news of increasing the capital gains rate to assist in funding these initiatives (even though, to be technical, it was a new release of previously announced intentions). The selling stalled during the following days as investors realized that it might not be so easy for the White House to pass a new 43.4% capital gains rate into law.
The proposed capital gains hike targets the wealthiest households, those making $1 million or more per year. The capital gains tax rate was last raised in 2013. According to Goldman Sachs’ review of the Federal Reserve’s distributional financial account data, in 2013, the wealthiest households sold about 1% of their stocks. Today, liquidation of 1% of the equities held by these households would equate to about $178 billion of stock sales. That’s relative to a total U.S. stock market capitalization of about $49 trillion.
There were capital gains tax hikes in 1987, 1988, and 2013. Six months before the increase, the S&P 500 got shaken, but it wasn’t that bad, on average. And then the index rebounded nicely in the following six months.
So-called momentum stocks, however, took it on the chin. And they barely got back up for the count. I’m not saying capital gains taxes won’t go up; I think they will. When those taxes increase, we’ll have to consider what to do with our stocks, especially our high-flyers with low-cost basis. Perhaps I am naïve, but I do not believe that the capital gains tax rate will go all the way up to 43.4%. If it does, I won’t bet on the type of snap-back rally that the S&P 500 has historically experienced.
I do expect U.S. corporate tax rates will rise from 21% to 28%. That increase is detailed in Biden’s proposal to pay for the American Jobs Plan. This would repeal the changes made by the Tax Cuts and Jobs Act in 2017. According to the Tax Foundation, “an increase in the federal tax rate to 28 percent would raise the U.S. federal-state combined tax rate to 32.34 percent, highest in the OECD (Organization for Economic Cooperation and Development) and among Group of Seven (G7) countries, harming U.S. economic competitiveness and increasing the cost of investment in America.” Based on those comments and investor intuition, one might expect stocks to take a knee due to such a devastating body blow.
Or maybe not.
BMO Capital Markets tracked the stock market’s movements during periods when the U.S. corporate tax rate was previously raised. BMO cited that this would be the first increase in corporate rates since 1993 and the sixth hike since 1945. The BMO report revealed that “during the five prior corporate tax rate increases in 1950, 1951, 1952, 1968, and 1993, the S&P 500 index posted an average calendar year gain of 12.9% with positive price returns in each instance. This gain was well above the 4.6% average return registered during the nine annual periods when the tax rate was reduced and also higher than 9% price return for all calendar years going back to 1945.”
That’s not bad news. But correlation is not causation. As the BMO report pointed out, those returns were associated with booming economic growth. Real Gross Domestic Product (GDP) for those periods averaged a whopping 5.7%. It’s not surprising that the stock market performed well given such strong economic growth. BMO’s data does not conclude that higher U.S. corporate taxes are beneficial for the stock market. However, although counter-intuitive, the stock market apparently should be able to absorb the higher tax rates so long as the economy is performing well.
Not that I’m proposing one rate or another. I’m staying in my lane. And my lane is loaded with reasons to take an offramp — higher taxes, COVID-19 infections, irrational exuberance, stock bubbles, and more. I am staying on course and maintaining the equity allocation in my portfolio. There are some nasty potholes up ahead, but I’ll buckle up, ignore the offramp that brings me to the comfortable rest station, and be ready for any bumpy detours.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing investments of more than $500 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures. Direct inquiries: aharris@berkshiremm.com.
