Capital Pains? On the Latest Rumored Biden Hike

Editors’ Note: Our political commentary is intentionally non-partisan. We favor no political party nor any politician and assess political developments solely for their potential economic or market impact.

Investors have dealt with a lot of tax chatter over the past year and a half. This week added another, albeit widely expected, round: the Biden administration’s rumored plan to nearly double capital gains taxes for people earning over $1 million. We have seen a lot of hyperbolic talk about this sucking money out of the private economy, hurting growth and productivity—not to mention reducing demand for stocks following a wave of selling as the affected people race to lock in gains before the increase takes effect. We have also seen long defenses of the preferential long-term capital gains rate, which we sympathize with. But America has a long history of capital gains tax changes and, spoiler alert, they aren’t automatically bearish. We think President Joe Biden’s proposal is quite unlikely to differ, even if it passes exactly as advertised. One reason why? Next to no one would pay it.

If the rumors are accurate, Biden’s plan would jack up capital gains rates to 39.6% on these high earners. That rate would be up from 20% currently and slightly exceed the current 37% top marginal income tax rate. Actually, these folks’ gains would face a 43.4% rate when you add the Affordable Care Act surtax. Plus many states levy capital gains taxes, meaning taxpayers in higher tax states like New York or California would pay capital gains rates topping 50%. Hence, the uproar.

Now, from a pure logic standpoint, we sort of get the angst. For one, capital gains taxes are an example of double taxation. Publicly traded companies pay corporate taxes. Therefore, the value of a company and its earnings—which stock investors own—is all after-tax. From that standpoint, paying capital gains taxes would be like paying income taxes on withdrawals from a Roth IRA. Paying taxes on money you have already paid taxes on is, well, annoying and stupid. Two, it isn’t like most people who earn a million dollars annually are living off their capital gains.^[i] In many cases, realized gains aren’t used as cash flow. People are merely selling one stock to buy another. So if Uncle Sam doubles his cut, that takes a big bite out of the money available to reinvest, which—in theory—can hit stock demand. Whether Uncle Sam spends that money more productively is the subject of endless debate and a matter of opinion, but we generally think the market is likely to allocate capital better than politicians, regardless of their ideological bent, competency and character. 

But that is all just philosophy and opinion. Those aren’t market drivers. This is why it is critical to strip out all of your opinions and biases when assessing political developments’ potential market impact. Biases blind. So turn off feelings and opinions, and just look at the data. Congress has hiked capital gains taxes 10 times since 1968. S&P 500 returns, with dividends, are positive over the next 12 months 9 of those times, far above the index’s overall frequency of positive annual returns—and slightly higher than the frequency of positive returns after tax cuts. In the 12 months before the change, when the incentive to sell is theoretically higher, returns are still positive 7 of 10 times, right around the average frequency of positive returns.^[ii]

In short, capital gains tax hikes haven’t historically been bearish. We doubt this time goes different. After all, the above were broad capital gains tax hikes. Biden’s proposed hike is the opposite of broad. It would hit just 0.3% of all US tax filers, according to Bloomberg’s analysis of IRS data.^[iii] But wait! Even that number is probably too high, because this will probably be a very, very easy tax to avoid. Imagine a hypothetical high roller named Zelda Zillionaire. She raked in $1.5 million last year, theoretically exposing her to this astronomical new capital gains rate. What does she do? Well, we reckon she makes darned sure she doesn’t earn $1 million if she wants to sell stock this year.

It is actually pretty easy to avoid earning $1 million, and those who do earn that much have more options to reduce income than most of us. This is not a how-to guide, and it certainly isn’t tax advice, but options include donating to charity, asking your board to pay you with more stock options instead of cash and deferring salary. If excessive dividends and interest are the issue, there are loads of ways to minimize those. Movie stars might deduct what they pay to their stylists, trainers, yoga coaches and lifestyle gurus. Failing all that, people can make like the Rolling Stones and David Bowie and just move to tax-friendlier climes. Again, this is not tax advice! But you know who does give advice? The legions of accountants and lawyers who specialize in devising these strategies for people. Our hunch, therefore, is that this tax proposal will raise a lot of revenue for Big Tax Avoidance, but not much for the feds.^[iv]

This is always how it goes with niche taxes targeted at the super rich. It is why Europe’s wealth taxes never raised anywhere near as much as advertised. It is why France’s 75% tax rate on income exceeding €1 million died on the vine after raising barely any revenue. As a general rule, the more you tax something, the less you get of it. That is how incentives work.

If Biden’s tax plan passes (a big if, given the Democrats’ narrow margins in both the House and Senate), this is the benign reality people will eventually discover, paving the way for the positive surprise that usually lifts markets when tax hikes don’t bite as advertised. To the extent they weren’t already, the worries are getting baked in now, courtesy of all the chatter about the potential impact on big Tech and other high-returning stocks. Selling on that chatter now would be a mistake, in our view, as fear flips fast. Instead, remember bull markets climb a wall of worry, and tax dread shows there is more wall left.