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At long last, after months of sparring and insinuations, House Democrats have finally released a specific tax proposal. As with most proposed tax overhauls, it is broad and, if enacted, would create a range of winners and losers. Yet it is also much tamer than what several Democratic legislators and the Biden administration have called for, leaving out several rumored provisions that spooked investors earlier this year. Passage remains a big if, though, given the deep divisions within the Democratic Party and looming 2022 midterms. There is a long way to go between the House Ways & Means Committee’s vote, scheduled for this week, and actual new tax law. Still, the process thus far shows why overrating political chatter—especially in the tax realm—is a big investing error. Stocks’ history of fine returns after tax hikes is but one reason why.
Since the presidential primary campaign, investors have grappled with a number of big tax proposals. There was the wealth tax championed by some high-profile candidates. Some floated the idea of taxing unrealized capital gains or removing the step-up in cost basis that occurs when assets pass from a deceased owner to heirs. Oh, and lest we forget, steep increases to personal and corporate tax rates were a near-constant part of the conversation.
Compared to all of these earlier ideas, the tax package unveiled Monday was … kinda tame? It doesn’t include a wealth tax. It proposes replacing the flat 21% corporate tax rate with a graduated scale that ranges from 18% to 26.5% for businesses earning over $5 million annually—topping out higher than the 25% proposed by moderate Senate Democrats, but below President Joe Biden’s preferred 28%. It raises the tax rate on corporations’ overseas earnings but also bolsters several offsetting deductions. It raises the capital gains tax rate from 20% to 25% for select high earners but limits it to realized gains and leaves the cost basis step-up intact. (Perhaps as a tradeoff, it brings the estate tax exemption back down to pre-2017 levels.) It raises the top personal income tax rate to 39.6% and adds a 3% surtax on incomes exceeding $5 million, but it leaves tax rates and bands alone for individuals earning less than $400,000 and married couples filing jointly earning less than $450,000. For those affected, this may not be great news—few like paying taxes and even fewer like paying higher taxes. But it is a textbook case of reality exceeding expectations as political concerns chip away at radical proposals. It wouldn’t shock us if Congressional debate watered it down further, just as debate watered down the Republicans’ tax reforms in 2017.
There are two areas where one could argue the changes pack more of a punch: pass-through corporations and retirement accounts. Regarding the former, 2017’s tax reforms tried to make life easier for small businesses filing through their owner’s individual returns, so as not to disadvantage work-a-day business owners compared to large corporations. That included a provision shielding capital gains from the sale of some small business stocks from taxation—an exemption the proposed bill would limit to owners earning less than $400,000. Additionally, it slaps a 3.8% tax on all of these companies’ active business income, rather than just wages, passive income and self-employment income. So if you are a small business owner and are organized as an S-Corp, keep a close eye out for potential changes and consult your tax adviser as needed.
As for retirement accounts, a number of the changes making big headlines affect only the handful of people with incomes in the top tax bracket and IRA, Roth IRA or 401(k) balances over $10 million. In any year their accounts exceed this threshold, they will face a required minimum distribution (RMD) of 50% of the amount over the limit in the following year. While normal RMDs apply only to account owners age 72 and up (and beneficiaries), the Ways & Means Committee’s official writeup doesn’t mention any age thresholds, leading us to believe this applies to all ages. It also outlaws further contributions to traditional and Roth IRAs if the combined value of an individual’s retirement accounts exceeds $10 million and their annual income is in the top bracket. As best we can tell, this is aimed at capitalizing on the progressive wing’s outrage over ProPublica’s revelation that PayPal founder Peter Thiel’s Roth IRA is worth about $5 billion. It may also be a lot of hot air, considering Roth IRAs are funded with after-tax money and distributions from them are therefore not presently subject to income taxes if the account owner is over age 59.5 and the account is more than five years old. The legislation doesn't change existing rules governing taxation of Roth distributions, so qualified withdrawals would likely simply go to a taxable account, where they would be subject to capital gains taxes thereafter. (It is also fuzzy on whether or how these forced distributions would apply to younger taxpayers, however, injecting some uncertainty.)
The one change that would potentially affect less wealthy people is the provision eliminating Roth IRA conversions for people in the top tax bracket. Oddly, the official communiqué says this change would take effect at year-end 2031, which we strongly suspect is a typo, as everything else in this section takes effect at the end of this year. It would also outlaw the conversion of after-tax retirement account contributions to Roth contributions, a way higher earners have historically gotten around lower Roth income exclusions.
Again, it is far from certain that all or any of these changes pass exactly as outlined today, if at all. Ways and Means Committee Chairman Richard Neal is widely seen as a more moderate Democrat, and progressives in both chambers are likely to argue this doesn’t go far enough. At the same time, congresspeople and senators fighting for re-election in purple states have an incentive to slow-roll this, and some of the provisions cut against public positions of people like West Virginia Senator Joe Manchin. Another wild card here is the deduction of state and local taxes (SALT), which 2017’s reforms capped at $10,000. Democrats are divided over whether to raise it, but Neal signaled that a proposal for “meaningful SALT relief” is forthcoming.
But for argument’s sake, let us pretend it does pass. What then for stocks? In all likelihood, not much. Tax hikes and cuts alike have no preset market impact for good or ill. We have had 13 US corporate tax hikes since good market data begin in 1925. In the ensuing 12 months, the S&P 500 rose 9 times, averaging 11.1%.[i] On the personal income side, Congress has hiked the top bracket rate 14 times. The S&P 500 rose in the next 12 months after 10 of them, averaging a whopping 16.8%.[ii] Similar positivity holds after capital gains tax hikes. That doesn’t mean tax hikes are bullish, but it shows they are just one variable affecting the market’s economic drivers. Other factors matter more.
The real lesson here, in our view, is not to get too hung up on any tax changes whether you love or hate them. We warned of this four years ago, pointing out that any changes enacted by a narrow majority in one Congress can be undone by a narrow majority in the next. This proposal is a prime example. If we had our druthers, Congress would stop this song and dance of changing tax laws every few years, which makes it more difficult for individuals and businesses alike to plan and invest. The actual tax rate matters much less than knowing you can make an investment today and pencil in the future tax rate with reasonable confidence that it won’t change—that is crucial to calculating risk and return. The constant state of flux probably discourages risk taking. Not to the degree that would upend markets, obviously, but we do think it is an underappreciated long-term headwind.
In the meantime, though, if Congress passes these tax hikes and you don’t like them, you can probably sleep sound knowing a future Congress can easily undo them if they choose.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.