Capital Market Impact Weekly market commentary

Concerns rise over tax increase proposals

May 12, 2021

capital gains tax changes have had varied impacts on stock returns chart

The S&P 500® Index has rallied 25% since Election Day, in part due to the aggressive fiscal spending ambitions of the Biden Administration. This strong gain places the past six-month period into the top 3% of all such periods of performance on record.

While debates around the $4.1 trillion infrastructure and social programs continue, recent attention is focusing on how to fund this spending. The Biden Administration is considering several revenue-raising options such as higher corporate taxes, a minimum corporate tax and increased collection of taxes owed. Higher taxes on wealthy individuals is also in the mix, including potentially raising the maximum capital gains tax from the current 20% to 39.6% on individuals with incomes over $1 million.

A survey by Nationwide Retirement Institute of advisors and financial professionals between March and May this year indicates a high level of concern about tax policy. Of the 200 respondents, 32% noted that taxes are the most important macro issue impacting client portfolios. Other concerns (e.g., the federal deficit, the pandemic, government gridlock, inflation) pale in comparison.

In periods of stress and uncertainty, investors tend to want to “do something”. In this case, do something could mean selling to front-run changes to the tax structure. This reaction could be disruptive for both portfolios and the broader market. But history shows little correlation between changes in the capital gains rate and market returns. In an analysis by the Tax Foundation, there have been 22 changes to the maximum capital gains tax rate since 1954. In those years when capital gains tax rates changed, the correlation with stock gains was almost indiscernible at 0.004. If the Biden Administration wants to get sizable infrastructure and social spending packages through Congress, it will likely include raising taxes. But making emotional decisions in portfolios based on tax changes may harm long-term returns.

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