Impact of Tax Hikes on the Stock Market
President Biden’s potential tax hikes will have some impact on corporate earnings and the stock market. However, we don’t believe tax policy is the determining factor for stock market performance. In our view, the market’s ultimate path is more influenced by the fundamentals. Over the long haul, our research concludes that earnings, dividends, valuations, and Fed policy have more to do with market direction than anything else. So that is our focus, not tax policy or politics.
Taxes don’t drive markets
We think the US equity market can absorb higher taxes without major disruptions. In other words, we don’t recommend selling stocks now, just because taxes may be going up in the future. We are encouraged by the pace and durability of the economic recovery, and therefore maintain our positive outlook.
President Biden has been clear about plans to raise taxes for corporations, individuals with high income, and most recently for capital gains for millionaires. Markets have responded with some modest volatility, but so far, it’s been very short-lived. For example, when President Biden announced his intention to increase the capital gains rate to 39.6% for those earning $1M or more, the market cared… for about an hour on Thursday. Markets re-opened higher on Friday morning and were again trading near all-time highs into the weekend.
Positive outlook for stock investors
We think the outlook for investors is favorable, for the following reasons:
- The global economy is recovering,
- Corporate earnings are strong,
- Fed policy is supportive,
- Interest rates are low,
- The US consumer balance sheet is healthy.
Tax hikes might not be so high
The final version of the tax bill is very likely to be less than the proposed plan. The Senate is split between Democrats and Republicans, and in the House, Democrats hold only a slim majority. Some compromise may be required to pass higher taxes. Although we believe higher taxes are coming, the final version may be lower.
What if investors sell stocks to try to avoid higher taxes?
If some investors decide to sell stocks later this year, ahead of capital gains increases, the selling pressure will most likely be short-lived and reversed in 2022. In 2013, although the wealthiest households sold 1% of their assets prior to the rate hike, they bought 4% of starting equity assets in the quarter after the change and therefore only temporarily reduced their equity exposures in order to realize gains at the lower rate. Total household stock allocations demonstrated a similar pattern around the two preceding capital gains tax hikes (source: Goldman Sachs).
The ongoing focus on higher taxes could lead to more volatility through 2021. But we would expect opportunistic investors to step in on any such weakness and take advantage of lower prices.
The last time capital gains taxes were raised was 2013, and the S&P 500 index gained 30% that year.
We remain focused on the fundamentals. We are optimistic for markets to reward long-term investors.