The President of the United States in just under 100 days launched a mega stimulus plan to rescue the American economy from the effects of the pandemic and announced two others: the American Jobs Plan, aimed at investing in infrastructure and generating jobs, and the American Families Plan, aimed at subsidizing preschool and college education and expanding tax credits for low-income families.
Biden claims his plan will only affect the wealthiest citizens. It involves an increase in the marginal income tax rates paid by Americans with incomes above $500,000 a year, raising current rates from 37% to 39.6%.
Corporate America will also see a substantial increase in its taxes, from 21% to 28%. But perhaps the most controversial tax is the increase in the capital gains tax, which practically doubles the existing 20% to 43%.
Although there are red flags regarding the capital gains tax increase, most investors have a diversified portfolio ranging from taxable accounts to tax-free accounts such as 401(K)s (a tax-advantaged defined contribution retirement account offered by many employers to their employees).
How will the market react to Biden’s tax plan?
According to the Tax Policy Center, only one-fifth of corporate stocks are held in taxable accounts. The rest is held in tax-exempt accounts such as pension funds, retirement accounts or assets owned by foreign investors.
In the past, in times of high capital gains increases, the main U.S. financial index, the Standard & Poor’s, returned 1.4% on average, three months after the 1969 hike. Since the ’69 reform, the capital gains tax underwent three other increases in 1976, 1987 and 2013.
However, after the ’76 reform, the markets fell as much as 30% during 1978. While in 1987 the markets would face a drop similar to that of ’76.
Even so, overall market performance was not affected over the long term and investors accommodated to the tax increases.
Although 75% of stock owners will not be affected by the increase in the capital gains tax, the wealthiest 1% of Americans control about 50% of the stocks in the market and 38% of the financial assets in the U.S., so any moves these players make in reaction to the tax reform will have a butterfly effect on the rest of the market.
For many investors, locating in some states such as California or New York would no longer make economic sense, since in these states, they would face rates of almost 60%, while in states such as Texas, which do not have their own capital gains tax, would become more attractive for investment.
The stock market will no longer be more attractive to many investors, as they may be penalized for investing, so we would see a less dynamic market and more difficulty in raising funds for those companies that are just going public.
We could also see a considerable reduction in new startups and risky investments such as the development of new technologies and products. About 90% of startups in the U.S. are not profitable, plus the increase in capital gains tax, which would ultimately discourage investment in these risky businesses.
According to the Tax Foundation, in the long term, the increase in this tax would cost 159,000 jobs to the American economy, and would reduce economic growth by 0.8% and real wages by 0.7%.
Despite the apparent costs of reform, the market still seems unconvinced that Biden’s tax reform will pass unchanged. Within the Democratic Party itself, Biden does not have unilateral support for it.
In any case, to pass reform, the Democratic leader would have to convince a list of skeptics like Sen. Mark Warner (D, VA.) who opposes such a steep increase in the capital gains tax: “I think there should be some differential, but the differential between ordinary income and capital gains is too large, so I’m open to reducing that.”