Will Tax Hikes Kill the Bull Market? Trending Conversations 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 Sources: Federal Reserve Bank ofSt.Louis, 12/31/20. federal budget deficit. deficit. budget federal The upshot is a substantialof the widening US a result of the weakness in economy activity. government hasbeen collecting less revenue as spending.the At sametime, the federal currently seeking an additional $1.9 trillion in is administration Biden The economy. the support to in spending trillion $3 over committed has already economy, the many of segments on impact devastating its and outbreak coronavirus federalThe US government,its in responsethe to Spending is Outpacing Revenue by a Wide Margin a Wide Spending by is Outpacing Revenue The Problem The FederalTax Receipts Spending and Percent of US Gross Domestic Product 30% 20% 35% 25% 10% 15% 1962 Federal Government Outlays (% of GDP) of Government (% Outlays Federal 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 Federal Government Receipts (% of GDP) of (% Receipts Government Federal 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Spending Revenue 2016 2018 2 2020 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.