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CLIENT QUESTION OF THE WEEK: What impact will the proposed tax hike have on the stock market? Thumbnail

CLIENT QUESTION OF THE WEEK: What impact will the proposed tax hike have on the stock market?

The impact of a potential tax hike has been on many investors’ minds recently. As part of President Biden’s proposed infrastructure package, dubbed the American Jobs Act, various spending programs were included in which part will be paid for with the proposed increase in corporate taxes from 21% to 28%. This isn’t the first time the topic has come up and certainly won’t be the last, as with a new administration comes new policy. 1

While tax changes, specifically tax hikes, are always a source of angst, investors should be careful to extrapolate the impact of tax policy on their portfolio. The common train of thought is that low taxes boost markets and high taxes hurt markets, but it’s not that simple. For example, Presidents Ronald Reagan and George W. Bush implemented tax cuts during their administrations. If you had invested $100 in the S&P 500 at the start of each of their administrations, it would have grown to $324 under Reagan and declined to $70 under Bush. 2 In 2013, the Bush tax cuts expired for those making more than $400,000; in effect, this was a tax increase on income above that range. The S&P 500 increased in 2013, 2014, 2015, and 2016; highlighting that the tax increases did not cause a market collapse, a worry that many investors have during times when we experience tax hikes.

Additionally, a key point to remember about President Biden’s proposed tax plan is the uncertainty of it. President Biden initially unveiled his infrastructure plan back in March of this year, which included roughly $2 trillion in spending over eight years and an increase in the corporate tax rate to 28% to fund it.1 On April 22nd, as a counter to the plan, Republicans presented an alternative infrastructure package worth approximately one-quarter ($568 billion) of Biden’s $2.3 trillion original plan. Since then, there have been multiple conversations where both parties presented additional proposals trying to find a middle ground. Reuters reported on June 9th that Republican Senator Mitt Romney stated that members of a bipartisan group had reached tentative conclusions on a plan nearing $900 billion in which they will not be raising taxes as a means to generate revenue for a revitalized US infrastructure program.3 At this point, it’s too early to say if this bill will pass in its current form, but we can be sure there will be additional provisions proposed and conversations had.

Another point of consideration – to pass a tax increase, it’ll have to get through the senate. The Senate is divided 50-50, with Democrats in control because Vice President Kamala Harris can cast a tie-breaking vote. However, senators can side with the other party when it comes time to vote, and we’ve seen this happen many times before. All this to say, there is a tremendous amount of uncertainty around if the tax changes will pass and what form they will take.  

In thinking about the potential impact from a theoretical standpoint, it’s critical to remember that security prices reflect the expectations of market participants, including expectations about potential impacts of future tax rates on the future cash flows and discount rates of companies. Additionally, prices change almost instantaneously as new information becomes available, changes which may occur well in advance of when tax policy changes are finalized or implemented.

Respecting tax policy and how it affects markets, Dimensional has conducted analysis on the relation between equity market return and the tax burden scores available from the Heritage Economic Freedom Index. These scores are computed annually using the top marginal tax rate on corporate income, individual income, and the overall tax burden relative to GDP for each country. Their research finds that there is no discernable pattern between tax burden scores and average returns. They also looked at changes in tax policy, including the imposition of higher corporate taxes and found that market returns have been positive regardless of a country’s change in tax burden.

The imposition of new taxes and other tax policy changes are events that take a while to be implemented and are largely anticipated by the time they are enforced. As such, stock market prices are likely to reflect the expected implications of those changes in the months prior to enactment, and there is little evidence that one can consistently outguess market prices and exploit information not yet reflected in prices.

1 President Biden unveils his $2 trillion infrastructure plan – here are the details
2 Sourced from Dimensional’s Returns Web Program. Dimensional is Dimensional Fund Advisors LP.
U.S. senators push for infrastructure plan that avoids tax hikes 
This information is not intended to be investment advice. Past performance does not guarantee future results. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.