Investors Shrug Off Higher Taxes For Good Reason 

Stocks continued to rally in April, with the S&P 500 returning more than 5.3%. The increase came despite President Biden announcing plans to raise taxes on investment income for households earning more than $1 million per year. 

Biden’s plan marks a significant shift in U.S. tax policy. For the last several decades, tax rates have favored investment income over labor income, except for a brief period of parity from 1988-1990. While this news is noteworthy for clients and their advisors, the stock market’s muted reaction is understandable since Biden made no secret of his intentions throughout the campaign. Investors have likely already started to discount changes to the tax code and, for now, decided that the improving COVID and economic environments outweigh the risk from higher tax rates. 

Source: U.S. Treasury 

While Biden may have telegraphed his aim to increase taxes, the market’s reaction thus far is consistent with past increases to the capital gains rate. In 1987, capital gains rates moved from 20% to 28%. Pundits, expecting increased selling pressure from investors locking in gains at lower rate, were surprised when the market was nearly unchanged, declining less than 2% over the six months leading up to the tax hike. More surprising, the S&P 500 went on to gain more than 25% over the subsequent six months. In 2013, rates moved upward from 15% to 25.1% (when accounting for the Medicare surtax and phased out deductions). Similar to 1987, stocks climbed nearly 6% before the hike and added an additional 13.8% afterward.  

 Source: U.S. Treasury and Standard and Poors

This may seem counterintuitive to readers as increased tax rates reduce the after-tax return on investments. So, why does the market shrug them off so easily? There are at least three reasons:  

  • Very few investors pay capital gains taxes. According to the Tax Policy Center, about 40% of U.S. corporate equity is held by foreign investors not subject to capital gains rates. A further 30% is owned by retirement plans, which are exempt from taxes. Taxable investors only own approximately 25% of U.S. equities. While high–income taxpayers dominate this group, they tend not to make substantial moves due to capital gain tax policy changes. A recent Goldman Sachs report estimated that during the 2013 tax hike, these households lowered their overall equity allocations by just 1% and reverted to prior levels within six months. 

  • Tax-based selling is a zero-sum game. Investors have historically opted to lock in gains on winners and redeploy the proceeds into new companies rather than take their money out of the market. In fact, stocks that exhibited relatively stronger momentum have tended to experience lower returns in the run up to the tax increase. This is due to investors re-positioning within their portfolios while keeping their overall equity allocation steady.  

Source: U.S. Treasury, MSCI, Standard & Poors

  • To use a familiar refrain from the last decade, There Is No Alternative (TINA). Investors desiring to earn a reasonable rate of return on their savings have few options. Municipals bonds offer tax-free income, but they are unlikely to provide enough return to replace equity allocations in a client’s portfolio at the current level of interest rates.

Investors choosing to stay put may exacerbate a longer-term problem: trapped capital. Tomorrow’s innovative solutions require investment, and increasing the cost of re-allocating capital hinders progress. As an example, we have seen considerable interest from clients to transition their portfolios to sustainability-themed investments. However, the enthusiasm is often tempered by the transaction costs from making such a move. Even the current rate of capital gains taxes has proved prohibitive for many clients, forcing them to spread out the conversion over multiple tax years. It is paradoxical that investors trying to do the “right thing” are slowed by tax policy. Increasing capital gains rates raises the hurdle for these investors. We hope that policymakers work towards more innovative solutions that lower the cost of deploying capital to needed areas aligned with public policy goals. Opportunity Zones, which incented investors to deploy capital in historically economically disadvantaged areas, are a great example of this.   

Investors should be mindful of potential tax changes and work with their advisors to optimize the after-tax returns of their portfolios. However, we caution against taking action that may upset your long-term financial plans. While the tax changes proposed by President Biden may have a meaningful impact on some investors, we believe, the long-term case for holding equities remains strong.