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Biden’s Capital Gains Tax Hike: What That Means For The Market

Capital Gains Tax
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EDITOR NOTE: Joe Biden wants to raise the capital gains tax for the highest earners to a whopping 39.6%! Investors are worrying whether this may prompt a surge of selling, causing the stock market to collapse should Biden win this November. A similar thing happened in 1987 and 2012, under Reagan and Obama, respectively. And if you think an almost 40% tax rate is the highest historically in the US, remember that in the early 1950s, the tax rate for the wealthiest Americans was as high as 92%. In short, it’s much more complicated than you think, and this article explores all of the factors that feed into this figure, making the outcome difficult if not nearly impossible to forecast. Either way, however, hedging the outcome (mitigating uncertainty), regardless of the direction it takes, is always a wise idea.

Democratic presidential nominee Joe Biden’s plan to increase the capital gains tax could lead to a large-scale sell-off of stocks, according to economic analyses.

As part of his $4 trillion tax plan, Biden has proposed increasing the top tax rate for capital gains for the highest earners to 39.6% from 23.8%, the largest real increase in capital gains rates in history. Economic analyses show that capital gains tax hikes cause a burst of stock-selling in advance of the increase, as investors look to lock in the lower existing tax rates before they rise.

A research paper by Tim Dowd, a senior economist at the U.S. Congress Joint Committee on Taxation, and Robert McClelland, a senior fellow at the Urban-Brookings Tax Policy Center, found that the two previous hikes in capital gains taxes lead to a wave of selling.

In 1986, as part of the Reagan tax plan, the top rate for capital gains jumped from 20% in 1986 to 28% in 1987. In the months before the increase, capital gains realizations — or sales of stocks and other assets — surged by 60%. In 2012, as part of the fiscal cliff negotiations, the top rate went from 15% to 23.8%. Again, in the months leading before the change, capital gains realizations and sales jumped, by 40%.

Dowd and McClelland say that just ahead of a tax increase, investors sell stocks or other assets that have gained value before the higher tax rate becomes effective.

“The short-run effect involves taxpayers rebalancing the timing of their planned sales to correspond to the timing of tax rates,” according to the analysis. “The spikes also include realizations that occur to take advantage of what has become a temporarily low tax rate.”

Analyses show that every 10% gain in the capital gains tax rate leads to a 7% change in capital gains realizations. That suggests Biden’s rate increase — which represents a 66% effective increase in the rate, could lead to a 45% to 50% increase in capital gains sales, which could create a large downward force in the market.

Yet economists say that while stock sales could surge right before an increase, the stock market as a whole wouldn’t necessarily fall just because of the tax increase. The stock market continued to rise in 1986, for instance, even as investors realized capital gains before the tax hike. Markets had a more bumpy ride in late 2012 and early 2013, due in part to broader government dysfunction and the threat of a government shutdown.

Economists say that while there would likely be spike in stock sales if Biden wins and gets a tax increase, the effects on the overall market could be be offset by other factors. Biden’s tax increase would only apply to taxpayers earning more than $1 million, so the pool of sellers could be smaller than the investors affected in 1986 and 2012. The share of the stock market owned by individual investors — or those who are subject to the tax — has also declined over time, reducing the impact of a tax hike.

Research by Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, and Lydia S. Austin, a research assistant at the center, found that the share of all corporate stocks owned by taxable individual investors has fallen from 84% in the 1960s, to 24% in 2015. That means that three-quarters of the stock market is owned by institutions — pension funds, retirement accounts, foreign investors and pass-throughs — that would not be subject to a capital gains tax. And only a portion of the 24% — those with incomes over $1 million — would be affected by any Biden tax, so the effects would be diluted.

More importantly, economists and market experts say that over time, the overall direction of the market tends to be driven more by broader factors — interest rates, economic growth, corporate earnings — than by a single tax policy. With interest rates so low, there are few other places for investor to put their cash if they sell. Some market experts say investors could sell their stocks to capture the lower rate, and then jump right back into the market — limiting any market decline.

“An increase in the capital gains rate would always lead to sales of equities and securities prior to the effective date of the increase,” said Roger Altman, founder and senior chairman of Evercore and a Biden supporter. “That will happen every time. But the long-term effects are not historically negative. And those long-term effects depend on broad macroeconomic factors, not just the capital gains rate.”

Originally posted on CNBC

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