A version of this analysis from Invesco Global Market Strategist for North America Brian Levitt appears HERE with accompanying charts and illustrations difficult to reproduce. It's worth taking a look . . . and signing up for more insights from the Invesco team.
Will tax hikes kill the bull market?
The Problem: Spending is Outpacing Revenue by a Wide Margin
The US federal government, in its response to the coronavirus outbreak and its devastating impact on many segments of the economy, has already committed over $3 trillion in spending to support the economy.
The Biden administration is currently seeking an additional $1.9 trillion in spending. At the same time, the federal government has been collecting less revenue as a result of the weakness in economy activity.
The upshot is a substantial widening of the US federal budget deficit.
The Response: The Biden Administration is Proposing Tax Increases
The Biden administration is proposing tax increases designed to generate revenue and to reduce the income gap between the nation’s higher and lower earners. Among the proposed changes to the tax code include:
-
Increasing the corporate tax rate from 21% to approximately 25% to 28% likely starting in 2022 and establishing a corporate alternative minimum tax
-
Restoring the top marginal tax rate from 37% to 39.6% for taxpayers earning over $400,000 of annual income and lowering the value of income tax deductions
-
Increasing the capital gains tax rate to approximately 25% to 28% for households earning over $1 million per year
Biden’s tax proposals would be large from a historical perspective. It is estimated the tax plan would increase federal revenue by over $140 billion in 2021 and over $300 billion in 2022 and by a total of $3.1 trillion from 2021 to 2030.
While the expected revenue effect from the tax increases is likely to be large, it is important to note that the corporate tax rate is still likely to be well below the average corporate tax rate over the past decades, including during the second term of the Obama administration.
Over the Decades, Markets Have Generally Performed Well in Different Tax Regimes
There is little in the historical data to suggest that the US equity market has been primarily driven by changes in the tax code:
-
In the 1940s and 1950s, US equities performed well even as tax rates were rising.
-
In the 1970s, equities posted below-average returns even as tax rates were declining, as the market was being driven by inflation concerns.
-
Equities performed well in the 1980s and 1990s amid lower taxes but underperformed in the 2000’s in the aftermath of the Bush tax cuts, the result of the tech bubble and the global financial crisis. Markets, in the 2010’s, surged from the depths of the global financial crisis, even as individual tax rates were increased.
We would caution against drawing any hard conclusions on this analysis. There are often many other factors at play, including, but not limited to, the stage of the economic cycle and the direction of monetary policy.
Markets Have Historically Performed Well in Years In Which Tax Rates Have Increased
The US stock market has largely performed well even in the years in which taxes—be it personal, corporate, or capital gains—were increased.
Most recently, the US stock market surged 30% in 2013 despite the Obama administration allowing the Bush-era tax cuts to expire at the end of the year.
In fact, US equities advanced by 100% from the time of the expiration of the Bush- era tax cuts to the Trump administration passing of the Tax Cuts and Jobs Act of 2017.
Many Companies Will Not Pay the Top Corporate Tax Rate; Companies Have Generated Earnings Growth in Different Tax Regimes
The median US company has historically paid an effective tax rate well below that of the statutory rate. This is expected to be the case going forward, although the Biden administration seeks a 15% alternative minimum tax to prevent businesses from paying little to no federal tax.
Historically, earnings have experienced a long- term upward trajectory including throughout periods in which the corporate tax rate was significantly higher. In fact, companies have been able to generate earnings growth across many different corporate tax regimes.
Admittedly, consensus earnings for 2022 may need to be revised lower but over time we would expect earnings to be more reflective of the nominal growth of the global economy rather than be based primarily on tax rates.
Only 1/4th of US Corporate Stock is Held in the Taxable Accounts of US Households
US household share of US equity ownership has declined from nearly 60% in the early 1980’s to 37% today (including a sizeable percentage held in defined-benefit plans). Thus, a large percentage of the stock market is owned by institutions including pension funds, retirement accounts, and foreign investors that would not be subject to a capital gains tax.
Further, the proposed capital gains tax will only apply to those households with income of $1 million per year or more. For reference, the top 1% of income earners starts below $500,000 a year. As a result, the number of Americans affected and thus potentially inclined to sell equities would likely be significantly lower than the investors affected in 1986 and 2012.
Investors Do Tend to Sell Ahead of an Increase in the Capital Gains Tax Rate
Inherent in investors’ concerns about an increase in the capital gains tax is that investors will dump their equity positions prior to the tax increase in order to lock in the lower capital gains rate, thereby driving markets meaningfully lower.
It is true that the two previous hikes in capital gains taxes (Tax Reform of 1986, American Taxpayer Relief Act 2012) led to an increase in stock selling. For example, the total capital gains realized in 1986 climbed by over 7% of US Gross Domestic Product, up from 3.9% the prior year. The increase in total capital gains realized in 2012 was not as drastic but noticeable, nonetheless.
Capital Gains Tax
US Equity Markets Performed Well in the Months Before and After the Prior Increases in the Capital Gains Tax
US equity markets, as represented by the S&P 500 Index, performed well in the fifteen months that included the year before the signings of both the Tax Reform Act of 1986 and American Taxpayer Relief Act of 2012 through the three months after the signing. In fact, the cumulative daily returns over those periods were 45% and 22%, respectively.
Changes in the Income Tax Rate Have Not Meaningfully Altered the Long- Term Trend Household Net Worth
Historically, changes in the income tax rate have not meaningfully altered the long-term upward trajectory of household net worth. In fact, household net worth has tended to trend higher even in significantly higher tax regimes than what is currently being proposed.
Case Study of the Past Decade’s Tax Changes Reveals That Performance Appeared to be Driven More by the Business Cycle than by the Tax Code
Investors often try to assess the relative implications for size and style based on potential changes to the tax code. A challenge is that most of the analysis is not statistically significant given the infrequency of tax- code changes and the limited history of the size and style indices.
We instead use the two latest changes to the tax code as a case study, comparing performance in the three years after the passage of the American Recovery and Reinvestment Act (enacted 1/2/13) with performance in the three years after the passage of the Tax Cuts and Jobs Act of 2017 (enacted 12/22/17).
Many investment strategists had expected at the time that the latter, which reduced the corporate tax rate from 35% to 21%, would be a boom for the higher-taxed small- capitalization companies and would promote the stronger economic activity typically required to unlock the “value” in the market.
Market leadership, however, did not change. Investors favored structural growth business (large and mid) in what continued to be a slow growth world.
This analysis suggests that market performance is likely more driven by the state of the economic cycle rather than by changes in the tax code.
