Wednesday, May 5, 2021
“Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes,” Benjamin Franklin
First off, we hope everyone has a happy and safe Cinco de Mayo!
One of the big discussions lately has been about how will higher taxes potentially impact the stock market. We’ve known since President Biden won the presidency and the Democrats secured control of the House and Senate that higher taxes were coming, likely in the form of higher corporate taxes and higher capital gains taxes on the wealthy—though probably not until 2022. It is worth noting though that stocks haven’t been fazed at all by all the higher taxes talk, as we just saw the best first 100 days for stocks under a new president since FDR.
With proposals for the $1.8 trillion American Families Plan (AFP) and $2 trillion plus infrastructure bill (known as the American Jobs Plan or AJP), higher taxes are needed to help finance the new spending. Let’s be clear though, with a 50/50 Senate (Vice President Kamala Harris breaks ties) and historically slim Democratic majority in the House, we think these final numbers will likely come in less than $3 trillion combined, as these initial numbers from the Democrats are starting points for negotiations.
Higher capital gains taxes on the wealthy are one way to pay for things, with the AFP proposing to increase the top tax rate on ordinary income to 39.6% from 37%, and capital gains and dividends taxes on those who earn more than $1 million to a maximum of 43.4% from the current 23.8%. Fun stat, only 0.32% of the population makes more than $1 million a year, so the truth is this won’t impact the other 99.68% of the population.
“We’ve known higher taxes were coming so this shouldn’t be a surprise to anyone at this point,” explained LPL Financial Chief Market Strategist Ryan Detrick. “Now here’s the catch, looking back at the times that taxes increased amid a strong economy, stocks did just fine. Given the strong economic outlook this year, you’d have to think history could repeat once again.”
As shown in the LPL Chart of the Day, in 1986 and 2013, capital gains taxes increased, but the economy was on firm footing back then, compared with the 1970s hikes, which saw an economy marred by higher inflation and sluggish growth. Not surprisingly, the two more recent hikes saw solid stock market performance, while the 1970s hikes didn’t. Is it as simple as how the economy is doing? It very well could be.
Corporate taxes are currently 21% and President Biden has discussed increasing the level to 28%. Although we think in the end the level will be more like 25%, the bottom line is higher corporate taxes are likely coming, which could knock a few percentage points off of future S&P 500 Index earnings growth.
So what happens after corporate taxes are raised? As the table below shows, muted returns a year out are normal, but interestingly stocks have consistently been in the green the three months before the official date of the tax increase, suggesting investors weren’t very worried about higher taxes on the horizon.
It’s always possible that higher taxes slowly take a bite out stock market returns over a longer time period than just a year, but if the concern is what all the talk about higher taxes may mean for markets over the next year, there’s not much historical evidence pointing to the potential for a bad outcome. The picture is murkier, though, with corporate taxes, which isn’t surprising, since stock prices are ultimately tied to earnings growth. But is often happens, markets seem to be more attuned to larger economic forces.
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All index and market data from FactSet and MarketWatch.
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