Will Tax Hikes Kill the Bull Market? Trending Conversations

Home , Revenue Act of 1943, Tax Reform Act of 1969, Tax Reform Act of 1986

Brian Levitt Global Market Strategist, North America

Not a Deposit Not FDIC Insured Not Guaranteed by the Bank May Lose Value Not Insured by any Federal Government Agency The Problem Spending is Outpacing Revenue by a Wide Margin

The US federal government, in its response to the Federal Tax Receipts and Spending coronavirus outbreak and its devastating impact on many segments of the economy, has already 35% committed over $3 trillion in spending to support Spending the economy. The Biden administration is currently seeking an additional $1.9 trillion in 30% spending. At the same time, the federal government has been collecting less revenue as 25% a result of the weakness in economy activity. The upshot is a substantial widening of the US federal budget deficit. 20%

15% Revenue

Percent of US GrossDomestic Product 10% 1972 1978 1974 1976 1982 2012 1962 1992 1970 1988 2018 1984 1986 1968 1998 2014 2016 1964 1994 1966 1996 1980 2010 1990 2002 2020 2008 2004 2006 2000

Federal Government Outlays (% of GDP) Federal Government Receipts (% of GDP)

Sources: Federal Reserve Bank of St. Louis, 12/31/20.

2 The Response The Biden Administration is Proposing Tax Increases

The Biden administration is proposing tax Past Tax Rates and Current Proposals increases designed to generate revenue and to reduce the income gap between the nation’s 60% higher and lower earners. Among the proposed changes to the tax code include: 50% • Increasing the corporate tax rate from 21% to approximately 25% to 28% likely starting in 39.6% 39.6% 2022 and establishing a corporate alternative 40% 37.0% 35.0% minimum tax ~ 25% to 28% • Restoring the top marginal tax rate from 37% to 30% ~ 25 to 28% 39.6% for taxpayers earning over $400,000 of Household annual income and lowering the value of 21.0% 20.0% 20.0% 20.0% Income > $1M income tax deductions 20% • Increasing the capital gains tax rate to approximately 25% to 28% for households 10% earning over $1 million per year

0% Corporate Tax Rate Top Marginal Income Tax Rate Capital Gains Rate

Sources: Bloomberg, taxfoundation.org, 12/31/20.

3 Historical Comparison The Biden Administration is Proposing Tax Increases

Biden’s tax proposals would be large from a First Fiscal Year Revenue Effect historical perspective. It is estimated the tax plan would increase federal revenue by over $140 Revenue Act '42 5.04% billion in 2021 and over $300 billion in 2022 and Revenue Act '41 2.20% by a total of $3.1 trillion from 2021 to 2030. Revenue & Expense Control Act '68 1.74% Revenue Act '51 1.52% While the expected revenue effect from the tax Biden Tax Plan '22 1.52% increases is likely to be large, it is important to Revenue Act '50 1.30% note that the corporate tax rate is still likely to be Current Tax Payment Act '43 1.16% well below the average corporate tax rate over Excess Profit Tax '50 0.97% the past decades (as shown on the next chart), Revenue Act I '40 0.91% including during the second term of the Obama Revenue Act II '40 0.71% Biden Tax Plan '21 0.68% administration. Tax Adjustment Act '66 0.60% Tax Equity & Fiscal Responsibility Act of 1982 0.53% Revenue Act of 1943 0.46% Crude Oil Windfall Profit Tax Act of 1980 0.44% Omnibus Budget Reconciliation Act of 1990 0.41% Tax Reform Act of 1969 0.39% Trump Administration Tariffs 0.38%

0% 2% 4% 6% Percent of US Gross Domestic Product

Source: Office of Tax Analysis, Department of the Treasury, Congressional Budget Office

4 The History Over the Decades, Markets Have Generally Performed Well in Different Tax Regimes

There is little in the historical data to suggest that the US Large Cap Equity Returns and Top Individual/Corporate Tax Rates by Decade US equity market has been primarily driven by changes in the tax code: 35% • In the 1940’s and 1950’s, US equities performed well Individual Individual Individual Individual Individual Individual Individual Individual Individual even as tax rates were rising. 61.8% 86.3% 90.5% 80.3% 70.2% 48.4% 36.7% 36.2% 37.6% 30% Corporate Corporate Corporate Corporate Corporate Corporate Corporate Corporate Corporate • In the 1970’s, equities posted below-average returns 14.7% 36.7% 50.9% 50.8% 47.9% 43.0% 34.7% 35.0% 35.0% even as tax rates were declining, as the market was 25% being driven by inflation concerns. 19.5% • Equities performed well in the 1980’s and 1990’s amid 20% 17.3% 18.0% lower taxes but underperformed in the 2000’s in the aftermath of the Bush tax cuts, the result of the tech 13.5% bubble and the global financial crisis. Markets, in the 15% 2010’s, surged from the depths of the global financial crisis, even as individual tax rates were increased. 10% 8.5% 7.7% 5.9% We would caution against drawing any hard conclusions on this analysis. There are often many 5% other factors at play, including, but not limited to, the stage of the economic cycle and the direction of 0% monetary policy. -0.9% -1.0% Investors, at a minimum, may take solace in this chart -5% indicating that markets have generally performed well 1930's 1940's 1950's 1960's 1970's 1980's 1990's 2000's 2010's in different tax regimes.

Sources: US Department of Treasury, Shiller, Yale database, 12/31/20. An investment cannot be made directly in an index. Past performance does not guarantee future results.

5 Market Returns Markets Have Historically Performed Well in Years In Which Tax Rates Have Increased

The US stock market has largely performed well Annual Price Return for US Large Cap Equities: Years Tax Rates Increased even in the years in which taxes—be it personal, corporate, or capital gains—were increased. 35% 30% Most recently, the US stock market surged 30% 30% 26% in 2013 despite the Obama administration 25% 22% 19% allowing the Bush-era tax cuts to expire at the 20% 16% 16% end of the year. In fact, US equities advanced by 15% 12% 11% 8% 100% from the time of the expiration of the Bush- 10% 7% 2% era tax cuts to the Trump administration passing 5% 0% of the Tax Cuts and Jobs Act of 2017. 0% -5% -10% -15% -11% Tax rate increase in: 1950 1951 1952 1968 1969 1970 1971 1972 1976 1987 1991 1993 2013 Personal

Corporate Capital Gains

Sources: Shiller, Yale database, 12/31/20. An investment cannot be made directly in an index. Past performance does not guarantee future results.

6 Corporate Taxes Many Companies Will Not Pay the Top Corporate Tax Rate; Companies Have Generated Earnings Growth in Different Tax Regimes

The median US company has historically paid an The Median S&P 500 Company Tends to Have Companies Have Generated Earnings Growth in effective tax rate well below that of the statutory an Effective Tax Rate Below the Statutory Rate Many Different Tax Regimes rate. This is expected to be the case going S&P 500 Index Annualized Earnings Growth by Decade forward, although the Biden administration seeks a 15% alternative minimum tax to prevent 55% 14% businesses from paying little to no federal tax. 12% 10.0% 10.2% Historically, earnings have experienced a long- 45 term upward trajectory including throughout 10% 7.6% periods in which the corporate tax rate was 8% significantly higher. In fact, companies have 35 6.0% been able to generate earnings growth across 6% 5.1% many different corporate tax regimes. 26% 4% Admittedly, consensus earnings for 2022 may 25 19% 1.4% need to be revised lower but over time we would 2% expect earnings to be more reflective of the 15 nominal growth of the global economy rather 0% than be based primarily on tax rates. 1985 2015 1995 2010 1990 2025 2020 2005 2000 1970's 1980's 2010's 1960's 1990's 2000's

Statutory rate (including federal and local) Average Corporate Tax Rate by Decade Median S&P 500 company effective rate 50.8% 47.9% 43.0% 34.7% 35.0% 35.0%

Sources: Organisation for Economic Cooperation and Development, US Department of Treasury, Bloomberg, 12/31/20.

7 Capital Gains Tax Only 1/4th of US Corporate Stock is Held in the Taxable Accounts of US Households

US household share of US equity ownership has Share of US Corporate Equity Market declined from nearly 60% in the early 1980’s to 37% today (including a sizeable percentage held 100% in defined-benefit plans). Thus, a large 90% percentage of the stock market is owned by 80% institutions including pension funds, retirement accounts, and foreign investors that would not be 70% subject to a capital gains tax. 60% Further, the proposed capital gains tax will only 50% apply to those households with income of $1 40% million per year or more. For reference, the top 30% 1% of income earners starts below $500,000 a 20% year. As a result, the number of Americans 10% affected and thus potentially inclined to sell equities would likely be significantly lower than 0% the investors affected in 1986 and 2012. 1971 1951 1991 1957 1974 1976 1979 1982 1962 1985 1954 1945 1965 1959 1988 2013 1993 1948 1968 2016 2019 1996 1999 2010 2002 2005 2008

Households Mutual Funds Pension and Gov Retirement Funds Foreign Investors ETFs Business Holdings Hedge Funds Other

Sources: US Federal Reserve, 4/30/20.

8 Capital Gains Tax Investors Do Tend to Sell Ahead of an Increase in the Capital Gains Tax Rate

Inherent in investors’ concerns about an increase Total Capital Gains Realized vs. Maximum Tax Rate on Long Term Gains in the capital gains tax is that investors will dump their equity positions prior to the tax increase in 8% 35% order to lock in the lower capital gains rate, Tax Reform thereby driving markets meaningfully lower. 7% Act of 1986 30% Housing It is true that the two previous hikes in capital Tech 6% bubble American 25% gains taxes (Tax Reform of 1986, American bubble Taxpayer Relief Act Taxpayer Relief Act 2012) led to an increase in 5% 20% stock selling. For example, the total capital gains 2012 realized in 1986 climbed by over 7% of US Gross 4% 15% Domestic Product, up from 3.9% the prior year. The increase in total capital gains realized in 2012 3% 10% was not as drastic but noticeable, nonetheless. 2% 5%

1% 0%

Total Capital Gains Realized Percentage of US GDP (LHS) Maximum Tax Rate on Long Term Gains (RHS)

Sources: Federal Reserve Bank of St. Louis

9 Capital Gains US Equity Markets Performed Well in the Months Before and After the Prior Increases in the Capital Gains Tax

US equity markets, as represented by the S&P 1986 2013 500 Index, performed well in the fifteen months that included the year before the signings of both 55% 25% +23% the Tax Reform Act of 1986 and American +46% American Taxpayer Tax Reform Act 1986 Relief Act 2012 Taxpayer Relief Act of 2012 through the three 45% 20% months after the signing. In fact, the cumulative daily returns over those periods were 45% and 22%, respectively. 35% 15%

25% 10%

15% 5%

5% 0%

-5% -5%

Sources: Bloomberg, Standard & Poor’s. An investment cannot be made directly in an index. Past performance does not guarantee future results.

10 Income Tax Changes in the Income Tax Rate Have Not Meaningfully Altered the Long- Term Trend Household Net Worth

Historically, changes in the income tax rate have Marginal Income Tax Rate and US Household Net Worth not meaningfully altered the long-term upward trajectory of household net worth. In fact, 100% $1,000,000 household net worth has tended to trend higher even in significantly higher tax regimes than what 90% is currently being proposed. 80%

70% $100,000 Log Scale

60%

50% Projected 40% $10,000

30%

20%

10% $1,000 1981 2011 1972 1975 1957 1987 1978 2017 1954 1984 1993 1963 2014 1996 1999 1966 1969 1990 1960 2020 2002 2005 2008

Federal Corporate Tax Rate (LHS) Household Net Worth (RHS)

Sources: US Federal Reserve, US Department of Treasury, 12/31/20.

11 Size/Style Case Study of the Past Decade’s Tax Changes Reveals That Performance Appeared to be Driven More by the Business Cycle than by the Tax Code

Investors often try to assess the relative implications for January 2013 – December 2015 January 2018 – December 2020 size and style based on potential changes to the tax code. A challenge is that most of the analysis is not (3 Years After the American Taxpayer Relief Act) (3 Years After the Tax Cuts and Jobs Act) statistically significant given the infrequency of tax- Morningstar Style BoxTM Morningstar Style BoxTM code changes and the limited history of the size and style indices. We instead use the two latest changes to the tax code 34% 43% 52% Large 10% 43% 80% Large as a case study, comparing performance in the three years after the passage of the American Recovery and Reinvestment Act (enacted 1/2/13) with performance in the three years after the passage of the Tax Cuts and Jobs Act of 2017 (enacted 12/22/17). Many investment strategists had expected at the time that the latter, 36% 41% 46% Medium 9% 32% 71% Medium which reduced the corporate tax rate from 35% to 21%, would be a boom for the higher-taxed small- capitalization companies and would promote the stronger economic activity typically required to unlock the “value” in the market. Market leadership, however, 22% 33% 46% Small 5% 29% 53% Small did not change. Investors favored structural growth business (large and mid) in what continued to be a slow growth world. This analysis suggests that market performance is likely more driven by the state of the Value Blend Growth Value Blend Growth economic cycle rather than by changes in the tax code.

Source: Bloomberg. * Returns are gross of fees. Indices cannot be purchased directly by investors. Style box returns are represented by Russell indices. Small-cap growth, small- cap blend, and small-cap value are represented by Russell 2000 Growth Index, Russell 2000 Index, and Russell 2000 Value Index, respectively. Mid-cap growth, mid-cap blend, and mid-cap value are represented by Russell Midcap Growth Index, Russell Midcap Index, and Russell Midcap Value Index, respectively. Large-cap growth, large-cap blend, and large-cap value are represented by Russell 1000 Growth Index, Russell 1000 Index, and Russell 1000 Value Index, respectively Past performance does not guarantee future results.

12 Index Definitions

The Credit Suisse Leveraged Loan Index is designed to measure the performance of leveraged loans in the United States. The Bloomberg Barclays U.S. Aggregate Bond Index is designed to measure the performance of investment grade bonds in the United States. The Bloomberg Barclays Global Aggregate Bond Index excluding the United States is designed to measure the performance of sovereign bonds excluding the US. The Bloomberg Barclays Municipal Bond Index is designed to measure the performance of investment-grade municipal bonds. The Bloomberg Barclays Limited-Term Bond Index is designed to measure the performance of limited-term US government and corporate bonds. The Bloomberg Barclays EM Local Currency Government Bond Index is designed to measure the performance of sovereign emerging market bonds. Bloomberg Barclays EM Hard Currency Aggregate Index is designed to measure the US dollar performance of emerging market bonds. The Bloomberg Barclays US High Yield Bond Index is designed to measure the performance of US corporate high yield bonds. The US Treasury 3-month Money Market is designed to measure the coupon accrual rate for US Treasury Floating Rate Notes. The JP Morgan Global High Yield Index is designed to measure the performance of global high yield bonds. The Citi World Government Bond Index (ex-USD) index is designed to measure the performance of international developed bonds excluding US dollar denominated bonds. The Alerian Master Limited Partnership Index is designed to measure the performance of publicly traded master limited partnerships in the United States. The S&P Low Volatility High Dividend Index is made up of 50 stocks in the S&P 500 Index that offer high yields and is designed to measure the performance of high yield dividend paying stocks. The Dow Jones Select Dividend Index measures the performance of 100 high dividend paying companies, excluding REITs. The S&P 500 Dividend Aristocrats index is designed to measure the performance of S&P 500 index constituents that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. The FTSE NAREIT Equity REITs Index is a market capitalization weighted index designed to measure the performance of real estate investment trusts in the United States. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Index measures the performance of small-capitalization stocks. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Index measures the performance of small-capitalization stocks. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell Midcap Index measures the performance of mid-capitalization stocks. The Russell Midcap Growth Index measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Value Index measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The S&P 500 Index is a market capitalization weighted index of the 500 largest domestic U.S. stocks. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.

13 Disclosures

The opinions referenced above are those of the author as of January 29, 2021, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward- looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. This is being provided for informational purposes only and does not constitute a recommendation of any investment strategy for a particular investor. Investors should consult a financial professional before making any investment decisions if they are uncertain whether an investment is suitable for them. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding tax penalties that may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax advisor for information concerning their individual situation. Risks: The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. Investing in stock involves risks, including the loss of principal and changes in dividend policies of companies and the capital resources available for dividend payments. Although bonds generally present less short-term risk and volatility than stocks, investing in bonds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. Bonds also entail credit risk and the risk of default, as well as greater inflation risk than stocks. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers. For US Audiences: NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. ©2021 Invesco Ltd. All rights reserved. For Canadian Audiences: Commissions, trailing commissions, management fees mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. Most references are US centric and may not apply to Canada. Publication date: February 10, 2021 Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license. ©2021 Invesco Canada Ltd 2/21 NA1564 THBM-PPT-1P Invesco Distributors, Inc.