President Biden’s proposal for tax hikes on corporations and wealthy individuals is creating investor uncertainty, especially as it relates to the capital gains tax increase. To understand the potential impact we analyzed capital gains tax changes going back to 1954, and the associated stock market impact. Our analysis suggests, 1) capital gains tax policy doesn’t have a meaningful impact on markets, and 2) investors should think twice before making any changes that are influenced by capital gains tax policy (especially given the potential for retroactive tax treatment).
Biden provides clarity – taxes are going up for rich Americans
Last week President Biden unveiled his tax plan and as expected the proposed plan includes significant tax hikes for wealthy Americans. Investors so far have focused on the potential increase in the top capital gains tax rate to 39.6% (from 20% – not including Obama’s additional surcharge) and the impact it could have on markets.
While we make no calls on the final magnitude of tax hikes and timing we do expect that, 1) taxes will be higher for wealthy Americans (individuals earning over $400k and households over $1mn), and 2) it will happen by 2022.
At the same time, we remind investors to maintain perspective, especially given the current maximum long-term capital gains tax of 20% (ex. Obama overlay taxes) is near the lowest levels since 1954.
Capital gains realizations (i.e. investor selling) haven’t historically been impacted by capital gains tax rate changes
To understand the market impact of a tax change it’s important to understand investor behavior. We began by looking at historical changes in the capital gains tax rate, either positive or negative, and how they impacted realized capital gains (i.e. investor selling of stocks).
We went back to 1954 and analyzed realized capital gains by year, noting specific years where there was a tax policy change. As the chart below highlights the data was largely inconclusive, as historic trends suggest there aren’t meaningful increases (or decreases) in investor realization of capital gains around tax policy changes. In fact, capital gains realizations (in absolute terms) tend to align more closely with the S&P 500 performance.
Digging deeper, we then analyzed holdings of corporate stock across taxable and non-qualified accounts. Looking at corporate stock ownership trends gives some explanation – ownership in taxable accounts has been trending lower since 1965 and today stands at roughly 25%. This fact, taken in isolation, would also suggest that any impacts on markets today should likely be transitory and self-correcting.
(a) Stock held in non-taxable segregated reserves to fund annuity contracts and whole life insurance.
(b) Dashed lines indicate authors’ estimates.
(c) Primarily government holdings, but includes equities in 529 savings plans.
Ultimately, our takeaway here was that investor behavior historically hasn’t been largely impacted by capital gains tax policy. And given most investors aren’t in the highest tax bracket, combined with the decreasing ownership of stock in taxable accounts, we wouldn’t expect to see a material change in trend.
Capital gains tax policy changes historically have not been market events
We then shifted our analysis to how markets have performed around capital gains tax policy changes. Going back to 1954 we analyzed the S&P 500 performance before new policies became effective (we used the three months prior), and in the subsequent 12 months.
Although the sample set is small, history would suggest that market performance isn’t materially impacted by tax policy. In fact, the average change in markets both before announcement and after is almost identical for capital gains tax increases and decreases, suggesting that investors are relying on other factors for their investment decisions.
Based only on Federal core capital gains tax rate. S&P 500 Performance is price only.
Note: This analysis was focused on investor impact of tax policy and therefore we did not consider the impact of corporate tax changes on markets. Historically we have seen markets react negatively to changes in corporate tax policy, but the impact is largely a “one-off” event as markets reset expectations for the future.
A great company is still a great company, even if you have to pay more on the gains
After reviewing historical market performance, capital gains realizations and capital gains tax policy we believe that most investors make investment decisions (including realizations) on more than just taxes. Any potential capital gains tax hike is a material event for an investor, but ultimately it does not change the underlying investment’s characteristics; a fundamentally great company is the same company at a 20% capital gains tax rate, or a 40% one. And given the majority of investors own stock in qualified (i.e. non-taxable) accounts, the increase in taxes is an immaterial event.
We encourage investors to not get caught up in the market hype and take a step back before making any investment changes based on tax policy, especially given the potential for retroactive treatment.
ENDNOTES
Disclosures
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.