Take Heart, Investors. A Higher Capital-Gains Tax Wouldn’t Be as Scary as It Sounds.

Shocked! Shocked! As in the classic line from the film Casablanca, the stock market somehow was surprised by reports that the Biden administration is set to propose a sharp increase in capital-gains taxes on high earners.

That’s even though that prospect had been discussed widely, including in this space, following Joe Biden’s inauguration as president in January. And it had been a major part of the Democrats’ platform during the election campaign last year.

Yet stocks hit an air pocket when the news was reported early Thursday afternoon, suggesting that the reaction was caused in great part by machines programmed to scan headlines. By Friday, the losses were more than recouped after human investors had time to read and reassess the reports.

Those indicated that the administration would propose taxing capital gains at the same rate as ordinary income for people earning over $1 million a year. The top bracket for them also would revert to 39.6% from the 37% peak rate under the Tax Cuts and Jobs Act of 2017.

The net effect would roughly be to double the rate on capital gains for these high earners, to 43.4% from the current 23.8%, including the 3.8% Obamacare levy on investment income. It would mean that, for the first time, some Americans’ capital gains would be taxed at a higher rate than ordinary income, such as wages and salaries, instead of getting favored treatment as it has during most of U.S. tax history.

None of these proposals has been officially announced or made yet; they’re likely to be outlined when the president addresses a joint session of Congress Wednesday evening. “The Biden tax proposals are an opening salvo in a negotiating process,” writes Greg Valliere, chief U.S. strategist for AGF Investments, in a client note. He and other Washington watchers look for the administration to seek a cap-gains rate of 28% or 30% for million-dollar earners, which would be about halfway between the current 23.8% and the 43.4% top rate reportedly under consideration.

And because it’s basically an unofficial trial balloon at this point, there are far more questions than answers about any tax changes that could be aimed at investors.

In its efforts to tax capital the same as labor, the administration also could seek to tax dividends at the same rate as ordinary income. Since 2003, these payouts have been taxed at the lower capital-gains rate, which helps to offset their double taxation at the corporate and shareholder levels.

Another reported target is the estate-tax exemption. The administration would seek to slash the current one of $11.7 million to $5.5 million. However, because the exemption effectively is doubled for couples, the change would affect only a small number of estates.

Potentially, a bigger impact would come from the elimination of the step-up in cost basis on inherited assets. That could produce a big hit on investments made years ago. For instance, if you invested $10,000 in the SPDR S&P 500 exchange-traded fund (ticker: SPY) when it debuted on Jan. 29, 1993, it now would be worth $159,472.86, according to Morningstar calculations. Under current law, if you were to die, your heirs would owe taxes only on gains above that appreciated value. Were the step-up in basis eliminated, your heirs would owe taxes on the gains above the original $10,000 cost when they sell.

Critics contend that the step-up in basis promotes dynastic wealth and inequality. But calculating the tax on hard-to-value assets, such as private businesses established years ago, can be nearly impossible. Even figuring the original price paid for long-held publicly traded shares would be tough.

The reported proposals also could have some unexpected effects, among them increased corporate leverage, according to Hans Mikkelsen, credit strategist at Bank of America. A higher capital-gains levy would raise the cost of equity, while a hike in corporate tax rates would lower the after-tax cost of debt, he writes in a research note. That would be negative for corporate credit ratings and default risk.

Investors could sell assets now to take advantage of the current capital- gains rate, given that few observers think any increases would be retroactive. However, even if a hike is approved by Congress—a very big if, given Democrats’ razor-thin majority in the Senate—UBS suggests that the impact on stocks might be limited.

Only 25% of U.S. equities are owned by U.S. taxable investors, with the remaining 75% held by people and entities not subject to capital-gains levies, such as pension plans and other retirement accounts, endowments, and foreign investors, according to a note to the bank’s clients. And UBS expects some of the unaffected investors to buy any dip in the stock market. That could help support share prices.

Moreover, investors have a lot of leeway in realizing capital gains. By deferring selling, you might pay a higher rate, but you’d also benefit from the continued growth of the assets, rather than paying the taxman now. Those with incomes that vary from year to year could realize capital gains whenever their annual income is under $1 million. Taxable income also could be reduced by charitable contributions or by shifting from taxable bonds to tax-exempt municipals, the bank points out.

The very rich are different from you and me, F. Scott Fitzgerald famously observed. In one aspect, they certainly are: having a myriad of ways to manage their financial affairs to minimize taxes.

However, even though the Biden White House’s tax proposals are certain to get watered down, that won’t reduce their headline risk, adds Valliere. His prediction: “The rich, corporate and individual, are vilified by the progressives who dominate the administration, and this will keep the stock market on edge.”