How Would The Market React To Biden's Tax Plan If He Wins?

As former Vice President Joe Biden continues to widen his lead in the polls less than seven days to the election, investors are weighing the effects of his policies on the markets and changing their portfolio. 

One policy of the democratic candidate which has harmed much attention from investors is the tax policy. Joe Biden has said that he plans to raise capital gains taxes on individuals who make over $1 million. The Biden proposal would see taxes double for those in that income bracket because of taxes levied on gains from selling stocks and other assets to ordinary income. This would increase taxes on capital gains from 23.8% to 39.6%, making it the most massive increase in capital gains rates in American financial history.

This proposal has been met with mixed sentiments by investors. Some have predicted that the Biden-tax approach would lead to a massive sell-off in the market as investors would want to reduce their portfolio size and sell stocks or other assets that have gained value before Biden gets to the White House (investors may want to consider a strategy to hedge long positions).

The move by investors may be logical considering the fact that research has shown a trend of stock sell-offs following an increment in capital gain takes. A study from Tim Down, senior economist for the United States Congress Joint Committee on Taxation, and Robert McClelland, senior fellow at the Urban-Brookings Tax Policy Center, found that increases in capital gains taxes lead to a wave of selling.

In 1987, President Ronald Reagan increased tax on capital gains from 20% to 28%. In the months prior to the implementation of the increase, sales of stocks and investable assets surged by nearly 60%. Similarly, in 2012, as part of the fiscal cliff negotiations, the tax rate spiked to 23.8% from 15%. Just like the previously cited case, sales of stocks and other assets surged by 40%. The report showed that investors time their planned sales of assets to correspond with the change in tax rates. In the same vein, spikes in the purchase of stocks and other assets are reflections of investors trying to take advantage of a low tax regime.

Also, an increase in capital tax gains would have a trickle-down effect on the ordinary American in more ways than what analysts may be envisaging. The increment would apply to corporate bodies whose profits would be reduced, and corporate taxes increased. The associated costs from this would be passed down to employees who would see a slight increase in their income taxes. This would mean that the purchasing power of the average American would be reduced. 

Furthermore, analyses show that a 10% gain in the capital gains tax rate yields a 7% change in capital gains realizations. This implies that Biden’s proposed tax increase could lead to a 45-50% increase in capital gains sales, which could create a bearish run in the market.

However, not everyone is fully convinced that Biden’s tax plan would trigger a massive sell-off in the market. Goldman Sachs believes that the reaction of the Democrats' proposal might not be dramatic as investors expect. Asset managers in the Wall Street firm believe that though wealthy investors would expectedly react to the change, it might only be short-lived.

Firstly, only 25% of stocks in the U.S. stock market are subject to taxes on capital gains. Within this 25%, those who would be affected by the Biden proposal make up a subset of this proportion. That means that 75% of the stock market would not be subject to a capital gains tax, which would dilute the effects of the sell-off from the subset of the 25% that are taxable.

Secondly, the market tends to react to broader macro-economic factors rather than just fluctuation in tax percentages. Interest rates, economic growth, corporate earnings have more effect on the markets rather than a single policy on taxation. The recent events in the market tend to buttress this assertion. Right now the market also has to negotiate the recent surge in coronavirus cases and lack of fiscal stimulus.

Goldman states that in the months leading to the 2012 rate hike mentioned earlier, the top 1% bought back more stocks than they had sold prior to the change, a pattern which the investment bank believes would reoccur. This led the bank’s analysts to forecast that the wealthiest 1% of Americans will be the largest drivers of total stock demand in 2021. 

The conclusion by Goldman emboldens the argument in certain quarters that Biden’s tax plan solves nothing. Biden has argued that the pandemic has increased the income inequality gap. This year alone, Amazon.com Inc AMZN founder and CEO, Jeff Bezos, has seen his fortune increase by $74 billion. Elon Musk has amassed $47 billion, while Mark Zuckerberg has seen his net worth increase by almost $15 billion so far this year. 

Raising capital gains taxes on the wealthy may create a situation where small business owners would be paying a higher marginal tax rate than wealthy people with investments. 17% of household wealth is held in private businesses, which have a large stock of unrealized capital gains. This implies that if your business fails, you are limited from deducting those losses from your taxes. Your gains are fully taxed. This paradox is a big hindrance to starting up a business, which invariably means economic growth could be slower. 

Whatever may be the case, the new tax regime would not take effect until 2022. Even so, wealthy people may still sit on gains on their capital through 2021, delaying the much-expected market sell-off.