How Worried Should Investors Be About Tax Hikes? Part 2

How Worried Should Investors Be About Tax Hikes? Part 2

Posted On April 30, 2021 1:02 pm

In Part 1 of this series, we examined the corporate tax increase the Biden administration is proposing to pay for the $2.3 trillion infrastructure bill.

JPMorgan crunched the numbers for us, and concluded that a modest 5% market downturn might occur, hardly anything to lose sleep over.

But President Biden has also proposed doubling the long-term capital gains rate for some Americans. So here’s what you need to know about that significant potential tax hike.

Some Americans Might Pay A Lot More… But Almost Certainly Not You

Currently, the top capital gains rate for Americans is 20% for the top tax bracket + the 3.8% for the ACA surcharge.

Under the Biden proposal, the top capital gains rate would match the income tax rate.

  • the top marginal rate would rise from 37% to 39.6%
  • for those making over $1 million 43.4% would become the new long-term capital gains tax rate

Such a much higher rate would certainly affect some investors severely. Crypto, property, and stock portfolios might have to be adjusted because the higher taxes could amount to millions or even tens of millions of dollars.

However, before you panic, remember that the higher tax rate would only apply to those making over $1 million per year.

  • about 0.3% of Americans

If you’re not in the top 0.3%, then your long-term cap gains rate, for stocks, property, crypto, pretty much anything remains 15% to 23.8%.

For almost all Americans (anyone making less than $200K per year) it’s actually between 0% and 15% and there are no current proposals to raise that.

But what if you’re lucky enough to make over $1 million? Surely, it’s time for action right?

I think it’s another potential negative in terms of putting some selling pressure on individual investors who are generally overweight some of the stocks with the biggest gains in tech, mega-cap tech. I think that’s another area where we could see some anticipatory selling ahead of this potential hike in capital gains.” – Savita Subramanian, managing director, head of US equity and quantitative strategy at Bank of America Merrill Lynch

BAC’s head of quantitative research thinks that a small fraction of high earners might be inclined to sell some big winners to avoid a much larger tax bill.

However, as some other analysts have pointed out, the increased cap gains rate might be retroactive to January 1st, 2021. In that case, the selling pressure could a lot less.

That’s especially true since tax planners were warning ultra-high net worth clients that higher taxes might be coming in 2022, or even 2021. Thus a lot of selling actually occurred in late 2020, though not in a panicked fashion.

The Street views a meteor hitting earth as having a better chance than this tax plan getting through and passing Congress, which speaks to why stocks are taking this in stride. Clearly, the tax rates are going up, but for now, it’s containable in the Street’s view.” – Dan Ives, managing director, equity research at Wedbush Securities

Mr. Ives correctly points out that just because higher taxes are proposed doesn’t mean that the actual increase in taxes is likely to be anywhere close to that high.

Consider this. Democrats have a 50-seat majority. VP Kamala Harris has to break any party-line vote, which would be a tie.

While the $1.9 trillion stimulus bill did pass 51-50, the Democrats have no margin of error.

And there are eight conservative blue-dog Democrats that all have to sign off on a 43.4% top cap gains rate.

How conservative are these Democratic Senators? Well, here’s some context for you.

During the $1.9 trillion stimulus debate, the non-partisan Senate Parliamentarian declared that the $15 dollar minimum wage proposal could not be passed through reconciliation.

This surprised no one and effectively meant the issue was dead. However, what was surprising is that no less than eight Democrats demanded a vote on the minimum wage hike, specifically so they could vote “no”.

Regardless of what you personally think of that proposal, surveys show that up to 70% of Americans are in favor of it. That’s even after the Congressional Budget Office said that 1.3 million jobs would be lost if it passed.

90% of Democrats are in favor of a $15 minimum wage.

These eight Senators, including Joe Manchin of West Virginia, John Tester of Montana, and Kyrstin Sinema of Arizona, wanted to go on the record opposing something that had zero chance of actually passing, and is extremely popular with their base.

Does this sound like a Senate that is about to more than double the capital gains tax rate for even the top 0.3% of income earners?

Is it likely that at least one of these blue dogs would vote “no”? This is what analysts mean by a very low risk, that Wall Street is basically ignoring.

The devil will be in the details. Will it be retroactive to Jan. 1 of this year, and then you wouldn’t need to sell right away?

Will it be at the beginning of next year? That all begs the question, will it get passed? There are a lot of moving parts.

One thing investors can be sure of is that taxes are going up, and we have to at least partially pay for all the money we’ve been spending on stimulus.”- Chris Grisanti, chief equity strategist at MAI Capital Management

Any bill of this size is going to be complicated. So is the $1.5 trillion human infrastructure bill that’s expected to be unveiled in full this week.

Many months of negotiations are expected. Wells Fargo estimates the earliest the infrastructure bill might pass is October. The Senate Parliamentarian has ruled that Democrats could potentially use budget reconciliation up to four times through the end of 2022.

  • $1.9 trillion stimulus
  • $2.3 trillion proposed infrastructure
  • $1.5 trillion American Family Plan proposal
  • $700 billion healthcare proposal

Now, these are some ambitious proposals to be sure. Combined with up to $1 trillion in student debt forgiveness that Biden is apparently considering, it would amount to potentially up to $7.4 trillion in total spending, much of which might be paid for by higher taxes.

But we can’t forget that a proposed bill isn’t good or bad for investors just because of its size or price tag, but what it’s likely to mean for the economy and corporate earnings down the line.

What The $2.3 Trillion Infrastructure Bill Could Mean For The Economy

Moody’s is one of the 16 most accurate economist teams in America according to MarketWatch. And here’s what Moody’s Chief Economist Mark Zandi estimates would be the result of the American Jobs Plan, the $2.3 trillion infrastructure proposal.

The most immediate impact in early 2022 is to marginally reduce growth. That is because the higher corporate taxes take effect right away, while the increased infrastructure spending does not get going in earnest until later in the year.

What kind of hit to growth does Moody’s model predict?

Moody’s estimates a negligible 0.04% drag on the economy assuming the 28% corporate tax rate goes into effect in 2022.

By 2023 the economic growth starts accelerating, peaking in 2024 at 3.8%, and then returning to just over 2% growth.

Moody’s estimates that thanks to the stimulus so far, growth through 2030 without the AJP would be 2.7% CAGR, and with it, 3.0%.

That’s a 10% boost to overall economic growth of 0.3% annually.

Moody’s estimates that an additional 2.7 million net jobs would be created by 2030 and unemployment would be 0.6% lower within eight years (when the spending stops).

Of course, this is merely the base case of a single blue-chip economist’s long-term forecast. There are other models from other economists that estimate slightly different economic effects.

Bank of America generally agrees with Moody’s and estimates a modest boost to growth from the proposal.

Various studies, including some by Mr. Zandi, and a meta-analysis of dozens of infrastructure stimulus studies, have concluded it’s one of the most effective forms of long-term stimulus.

In fact, the post-inflation return on investment is between 11% and 15%. With inflation-adjusted borrowing costs at 0%, infrastructure spending literally would pay for itself over time.

Thus it’s a bit ironic that both sides are demanding that part or all of the bill must be paid for with higher taxes when the stimulus bill was 100% deficit-financed.

But, while raising taxes that don’t need to be raised to pay for infrastructure that is necessary and would pay for itself over time may be suboptimal, the point is that even as proposed the AJP would likely be beneficial for long-term investors.

The effects of the American Family Plan and the healthcare proposal expected near year, can’t yet be estimated since those proposals have not been released.

However, if Moody’s and other blue-chip economists conclude that they result in a modest overall boost to economic growth, then that too would be a benefit for overall corporate profit growth.

Perhaps this is why Jeff Bezos has come out in favor of the AJP, and its 28% corporate tax proposal. Yes, Amazon would likely end up paying a 20% to 24% tax rate in that case, over $20 billion in 2026. But a stronger economy would allow Amazon to generate over $1 trillion in sales in 2027 or 2028 according to analysts.

The tax bill might be higher, but the net benefit to profits, cash flow, and thus shareholders would be bigger still.

In fact, in late 2020 Goldman Sachs estimated that had a $1 trillion stimulus package been financed partially with higher corporate taxes, it should have resulted in 4% higher earnings within four years.

The bottom line is this.

  • it will be many months before we know what higher taxes will actually look like
  • most Americans will not see a change in their taxes, including 99.7% of investors
  • modestly stronger economic growth this decade should mean very good things for S&P earnings

The time for panic is never, especially with your money. No matter what happens with tax-related headlines never forget the true story of Anne Scheiber.

In 1945, Mrs. Schieber invested $5,000 into US blue-chips. She had no formal Wall Street training, merely financial training from working for the IRS.

Using a 100% tax-efficient blue-chip strategy (buying companies like Coke and Bristol-Myers) she died in 1995…worth $22 million.

Mrs. Scheiber earned 18.3% CAGR total returns for 50 years. Buffett became the GOAT with 20.8% CAGR returns over 55 years.

The top marginal tax rate was as high as 90% while both Buffett and Scheiber were getting filthy rich.

Not through some complex speculative strategy, but merely a disciplined application of financial science.

Taxes are likely to go up. But that doesn’t mean you can’t still get rich. If you focus on quality first, and prudent valuation, and sound risk management always, you are almost certain to achieve your financial goals, no matter what happens with the AJP and AFP.

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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