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Biden’s opening bid: Initial thoughts on an ambitious agenda

Dave Donabedian, CFA

May 04, 2021

How might Biden's proposals impact investors?

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In recent weeks, President Joe Biden has proposed the biggest expansion of the federal government’s role in the economy since the 1960s. The American Jobs Plan (AJP) calls for $2.7 trillion in infrastructure investment over eight years, financed by a like amount of corporate tax increases raised over 15 years (reference What's in President Biden's American Jobs Plan?). The American Families Plan (AFP) lays out $1.8 trillion in social spending, financed mostly by tax increases on wealthy households. (Please see our Wealth Strategies Team companion piece, A Look at Biden’s (Early) Tax Policy Proposals, highlighting the tax increases proposed in the AFP.

The combined proposals are massive in size, scope and complexity. At this point, they have not been turned into proposed bills in Congress, and negotiations within Congress and between branches of government and the two parties are expected to go on for months. We don’t think it’s terribly useful to delve into the details at this point, since they are highly likely to undergo revisions. Instead, we view the proposals as the President’s “opening bid.” Given the Democratic Party’s scant majorities in both houses of Congress, the proposals are subject to moderation on both the spending and tax sides.

The fact that there are more unknowns than knowns has not prevented investors from wondering what it could mean for financial market returns, especially on an after-tax basis. Below we consider the impact of a potential rise in corporate taxes, as well as a higher capital gain tax rate on wealthy investors.

Corporate taxes

In 2021, corporate America is in the midst of a profit boom, marking a strong rebound from last year’s COVID-19 recession. Earnings for S&P 500 companies are expected to grow 29% this year. Early forecasts for 2022 call for a further 13.5% rise.[1]

But what if a major corporate tax increase goes into effect next year? The direct impact would be to reduce after-tax corporate profits. Full implementation of the proposed corporate tax increases could result in reducing the profit growth rate by more than half next year.[2]

On the surface, this could add to existing concerns that equity market valuations are stretched. If earnings next year only grow by 5% instead of the currently expected 13.5%, the price-to-earnings ratio would rise from 20.7x to 22.4x*—a high valuation compared to long-term averages. (*Valuation calculated using S&P 500 level on April 30, 2021.) This would be a material change, but not catastrophic, because there are two mitigating factors. First, given the gathering strength of the economy, we suspect current earnings estimates for this year and next may need to be revised higher (“ex” the tax increase impact). Second, the full extent of the president’s corporate tax proposal is unlikely to become law.

While tax increases on businesses would suppress earnings in the near term, proponents of the AJP would likely urge investors not to forget the investment part of the plan. Their belief is that a multitrillion-dollar infrastructure investment in the economy will improve productivity, create jobs and raise long-term economic growth rates—all of which ultimately accrue to the benefit of companies’ bottom lines.

We will also be paying close attention to the impact the proposal could have on particular industries. For instance, much of the appropriated infrastructure spending would find its way to the private sector. Traditional construction and engineering, as well as renewable energy-focused industries, would seem to be targeted beneficiaries. On the other hand, the provisions focused on increasing the tax bill for multinational corporations could be of particular concern for many large technology companies.

Capital gain tax

The White House proposal calls for a significant increase in the tax on realized investment profits (i.e., capital gains) for people with annual incomes above $1 million—from 23.8% to 43.4%.* The 43.4% rate would also be applied to dividends earned by those same households. This would be the highest tax rate on capital gains and dividends since the mid-1970s, though it would only apply to 0.3% of households. (*We are including the 3.8% Affordable Care Act surtax that also applies to capital gains.)

All else being equal, an investor subject to the new higher rate would have a lower after-tax return on profitable investments that are sold. However, that static mathematical approach misses an important variable: dynamic investor behavior. Investors build tax changes into their decision-making, impacting when and how they realize investment profits. The best evidence of this is that increases in the capital gain tax rate have not been associated with more revenues for the government. In fact, one of the reasons the near-50% tax rate in the mid-1970s was scrapped was that it produced lower federal revenues. Government legislates, investors adapt.

A broader question is whether stock market returns in general are negatively impacted by increases in the capital gain tax rate. First, let’s evaluate the short-term impact. The chart below shows the return on the S&P 500 six months after a change in the capital gain rate is signed into law. There have been eight changes to the rate in the last 50 years: four up, and four down. As the chart indicates, when the rate was raised, the stock market was lower two out of four times—a less than decisive message.

Chart 1: Change in capital gain tax rates and S&P 500 performance six months laterMore importantly, given our investment time horizon, there is no compelling evidence that the capital gain tax rate materially impacts the stock market’s long-term return. One reason is that only 25% of the value of the equity market is held by investors subject to the capital gain tax. Those exempt from capital gains include pension plans, individual retirement accounts and charitable endowments. Additionally, under the AFP, over 99% of taxable households would not be subject to the proposed higher rate, because they do not meet the $1 million income threshold.

We have been asked more than once in recent days if an investor potentially subject to the 43.4% capital gain tax should realize investment gains now at the current lower rate. At this point, we would counsel patience. As described previously, the legislative process will unfold over months. While it can’t be completely dismissed as a possibility, a capital tax hike has never been applied retroactively. So, there is likely time to assess developments.

Given some of the early feedback from members of Congress (including in the president’s own party), the 43.4% may not be viable, and a lower rate could eventually be settled on. Importantly, prioritizing taxes as the primary catalyst for investment decisions has a high probability of backfiring. In the case of a stock, the quality and growth potential of the company are likely to be bigger determinants of the after-tax investment return than the capital gains rate in effect at the time.

The other thing to remember is that there is no such thing as a permanent change to the capital gains tax. Any modification enacted in the months ahead would be the third in less than twenty years. In the decade ending 1986, the capital gains tax rate was changed four times.[3] Wherever it is headed in the immediate future, can anybody have confidence in what the rate will be five years down the road?

Conclusion

There is likely to be a good deal of uncertainty for most of this year regarding which policies within the AJP and AFP will become law, what will be watered down and what may disappear altogether. The Wealth Strategies and Investment teams at CIBC Private Wealth will keep you updated as the process evolves, assessing potential impacts on both wealth planning and financial markets.

 

Dave Donabedian, CFA is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.


1 FactSet, April 30, 2021.
2 Based on a survey of analyses from Wolfe Research, Strategas, UBS and BCA Research following publishing of the proposal.
3 Congressional Budget Office, February 2021.