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Written by: Poul Kristensen | New York Life Investments
The U.S. election is less than a month away, and investors are naturally concerned about the consequences. We’ve written before that it is real policy change, or the likelihood thereof, that shapes the investment environment—not short-term political dynamics.
That said, one of the major policy changes that could come is an increase in taxes.
In a recent episode of our Market Matters podcast, New York Life Investments interviewed Chief Economist Poul Kristensen on the potential for tax changes – both for companies and households – and how that could impact portfolios.
Question: Taxes are one of the most important market-related policy issues at stake in this election. What is the big picture for investors?
Poul: A Democratic sweep would make higher tax rates more likely. The Biden campaign’s current proposal, if implemented in full, would amount to about $4 trillion in increases to corporate and individual taxes over the next 10 years. However, these policies would not be implemented in a vacuum.
The Biden campaign has also announced plans to spend around $7 trillion, which means a net spending of about $3.0 – 3.5 trillion over 10 years, or more than 1.0% of GDP per year.
Campaign plans should always be taken with a grain of salt; realistically, this full list of proposals is unlikely to pass as announced. Still, it gives investors a hint of the policy direction.
Question: Let’s get into more detail on corporate taxes. Is it true that corporate taxes will move higher regardless of who is in charge?
Poul: As it stands, yes. The 2017 Tax Cuts and Jobs Act lowered rates, but it also put in place provisions that are slated to sunset in the years ahead. One example is the current bonus depreciation for business equipment, which is set to expire in 2026. The effective rate for corporations would thus increase if no new tax legislation were to pass.
Still, a Biden administration and Democrat-run Congress could increase corporate taxes further. The most impactful change is likely to be the overall corporate tax rate, which would cause a decrease of around 9% to after-tax earnings for S&P 500 companies. This is a headwind for investors. Other provisions, like a minimum book tax or bank levy, add some pressure for companies, but their impacts are smaller.
Question: If implemented in full, how would these changes impact investor portfolios?
Poul: Companies with low current effective tax rates would see a bigger hit to after-tax earnings. That puts a spotlight on consumer discretionary, technology, and healthcare. Companies with significant offshore activities would also see a bigger tax hike. There, tech and pharmaceuticals are in the spotlight.
Clients have focused on the negative impacts of these changes, but there are also opportunities for investors. Skilled active managers are capable of identifying which companies would be most impacted, and adjust their portfolios’ security and sector exposures accordingly.
Question: Moving on to individual tax changes, what are you focusing on?
Poul: Current proposals include an increase in the marginal tax rate (from 37.0% to 39.6%) for incomes over $1 million. Payroll taxes would also increase for incomes above $400,000. These changes will directly affect less than 2% of all households, and the headwind for the economy is likely to be moderate.
The change most likely to grab headlines is related to capital gains. Under the proposed changes, dividends and capital gains would be taxed as ordinary income for households making more than $1 million per year, and the basis for the estate tax would no longer be “stepped up,” meaning capital gains on those assets would increase.
While 99.7% of households would not see capital gains treated as ordinary income, high net worth individuals own significant amounts of stock, and could therefore have an impact on markets if they decide to lock in capital gains while taxes are low. This effect may be largest for companies with large capital gains over recent years.
Here, too, there may be an opportunity for investors. Companies with lots of cash on their balance sheets could decide to pay out a special dividend ahead of any proposed tax change, giving investors a chance to build income in that scenario.
Question: On the whole, should investors be concerned about these changes? Should they reduce risk in their portfolios?
Poul: Elections are notoriously difficult to predict, and timing markets is difficult, too. Staying invested and focused on long-term goals often pays off.
Investors should remember that tax proposals may not go into effect. Policy priorities can change—especially if the economy continues to reel for a while under the impact of the pandemic. Even if implemented, any increase in taxes is not going to happen in a vacuum, as it is likely to be of a plan that includes a significant increase in public investments to support the economy.
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