By Matt Phillips
May 4, 2021
Investors have largely shrugged off President Joe Biden’s proposal to raise taxes on investment income for wealthy Americans, as the stock market hovers near record highs after news of a strong economic rebound and blockbuster earnings reports from technology giants such as Apple and Amazon.
The indifference is well founded, analysts say.
Biden wants to raise taxes on the income that the country’s richest households make from investments — called capital gains — to fund his plans for economic-recovery and infrastructure projects. The increase would apply to people with annual income of $1 million or more.
In theory, higher taxes on investments like stocks should make them less appealing. But the outlook for economic growth and corporate profits is often a much bigger factor in the decision to buy, sell or hold on to a stock. And in a resilient market — when politicians typically propose them — higher taxes are even less of a deterrent.
“Markets can grow, and grow above trend, even if you’re taking the capital gains tax rate up,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets in New York. “That’s not the silver bullet that will kill the bull market.”
Calvasina’s team looked at what happens to the stock market when the capital gains tax rises. When the rate increased in past years, the team found, the S&P 500 index rose roughly 11%.
Proposed increases to the capital gains tax can cause momentary wobbles as investors try to lock in the appreciation on current investments, but the market usually regains its footing and shares climb higher.
“Any potential equity selling will be short-lived and reversed in subsequent quarters,” Goldman Sachs analysts wrote late last year about the prospect of a capital-gains tax increase under Democratic control in Washington.
That seems to be how the market is behaving. The news on April 22 that the Biden administration was considering lifting the tax sent stocks into the red, but the selling was limited. Stocks dropped just 0.9% for the day and bounced back a day later.Even after Friday’s 0.7% decline, the market sat on a comfortable gain of more than 11% this year. The S&P 500 was up 5.2% in April, its best month in 2021.
Investor stoicism may also reflect the fact that Biden’s plan requires congressional approval, a tall order given the slim Democratic control of both chambers. That reduces the likelihood that the proposed increase — which would tax ordinary income and capital gains income in the richest households at the same 39.6% rate — is enacted in its entirety.
“Most Democrats seem to be on board with narrowing the differential between the tax rate on capital gains and ordinary income, but there’s opposition for treating the rates as the same,” wrote analysts with Beacon Policy Advisors, a political consultancy. “This means there’s probably a middle ground for raising the capital gains rate on top earners to, say, 28%.”
If stocks continued their climb, it would largely be in keeping with previous periods when capital gains taxes were raised.
In 2013, when the tax rose to the current 23.8%, from 15%, on Americans with the highest incomes, the S&P 500 climbed nearly 30%. It was the best year for stocks in the last two decades. And after the top rate rose to 28%, from 20%, at the end of 1986, the market continued to roar higher, by nearly 40% through most of 1987.
Stocks eventually suffered their worst single-day collapse ever on Black Monday in October 1987, but that crash had little to do with tax policy, and the markets ended the year slightly higher. In 1991, a small increase to 28.9% in the capital gains rate for those with the largest incomes coincided with a 26% rise in the S&P 500. The major driver for that gain had nothing to do with taxes; it was the emergence from a recession.
Similarly, investors appear to be focusing on evidence that the economy is on the brink of breakneck growth. That surge is being fueled by a river of federal government spending, rock-bottom interest rates and more COVID-19 vaccinations. In the first three months of the year, the economy grew at an annualized clip of 6.4%. At that pace, 2021 would be the best year for growth since 1984.
Economic growth and corporate profits tend to rise together. And signs of additional oomph in the economy are already showing up in earnings reports from publicly traded companies.
Tech giants such as Tesla, Microsoft, Amazon, Apple and Google’s parent company, Alphabet, all reported first-quarter profits that trounced analyst expectations.
Now Wall Street analysts are ratcheting those profit forecasts even higher, expecting earnings for companies in the S&P 500 to jump more than 30% this year. At the start of the year, the forecast was a bit more than 20%. If the expected corporate profits appear, it will be their biggest bounce in over a decade.
Such growing optimism for profits — traditionally viewed as the key driver of stock prices — should far outweigh any impact of a tax increase, investors said.
Tax increases are “not the main event,” said Saira Malik, chief investment officer at the global equity division of Nuveen, a large asset manager. “The main event, for us, is earnings growth. Earnings growth, if you look, that’s what drives bull markets.”
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