As we noted last week, there is little historical evidence of an election bump or crash in the market. Further, History tells us little about which party the market prefers, as the market has marched upward over the decades regardless of the political party in charge. We continue to believe that the market is focused on other factors: corporate profitability, the debt cycle, and Federal Reserve policy to name a few, rather than the resident of the White House. However, policies can make an impact, notably tax policy can have a measurable impact on stock prices and the economy. This week we will analyze the Biden tax proposals and the potential impact on the market.
Corporate Tax Rates
Biden’s most notable and clear statement on tax policy is that he will increase the corporate tax rate from 21% to 28%, reversing the Tax Cut and Job’s Act (“TCJA”) reduction 2017. In addition, Biden has proposed a minimum “book tax” on corporations with book profits of $100 million or higher. The book tax appears to work like an alternative minimum tax where corporations will pay the higher of the regular tax rate or the book tax rate. Biden also proposes increasing the tax on foreign subsidiaries, and implementing a series of credits to incentivize manufacturing, particularly in the US.
However, it is the increase in the in the corporate tax rate that will make the biggest impact on the economy and the market. The Tax Foundation estimates that this policy will reduce Long Range Economic Output in the United States by 0.97%1. How will stocks react? That is difficult to assess, but the Tax Cut and Jobs Act did result in an increase in the corporate profit margin in 2018 from 10.9% in the 4th quarter of 2017 (pre-tax cut) to 12.3% in the second quarter of 2018, an increase of 12.8%2, which would imply an increase in stock prices of at least this rate. Regardless of your political position on the corporate tax rate, investors should be aware of a potential adjustment if this policy is implemented.
Personal Income Tax Rates
Biden has proposed a ‘partial’ repeal of the Tax Cut and Job’s Act’s tax breaks, targeting taxpayers with income above $400,000 for increase. The proposed changes include raising the individual income tax rate from 37% to 39.6% for those making more than $400,000, creating a new Social Security Tax of 12.4% on wages greater than $400,000, and increasing the capital gains tax rate to 39.6% (the ordinary income tax rate) for income over $1 million. Other provisions include capping itemized deductions for high earners and increasing the Child Tax Credit.
According to the tax foundation, the changes to personal income taxes have a relatively modest long term impact to the economy, in large part due to the fact that many aspects of the existing Tax Cut and Jobs act are scheduled to expire in 2026 anyway if congress does not act. The new Social Security tax for those making more than $400,000 is likely to have the biggest impact. Interestingly, the proposal would create a ‘donut hole’ for Social Security taxes where employers and employees pay 12.4% on the first $137,000 of income, then zero social security taxes until wages reach $400,000 where the tax begins again at the 12.4% rate.
Retirement Plans
One of the more interesting Biden proposals is a change in the way retirement accounts are treated for tax purposes. Under current law pre-tax contributions to a 401k plan are deductible for tax purposes. Biden proposes eliminating the deduction for 401k plan contributions and replacing it with a refundable credit of 26% for each $1 contributed to the 401k plan. Interestingly, Biden proposes depositing the credit into the 401k plan as a matching contribution rather than offsetting the current year’s tax bill.
The retirement provision has received very little attention in the press and appears to be somewhat dynamic at this point, so it is hard to determine if this portion of the Biden tax proposals would eventually become law. While technically revenue neutral, the plan would increase the progressive nature 401k contributions by providing a flat 26% benefit. Essentially, those taxpayers with existing tax rates lower than 26% would see an increased benefit, and those with an existing tax rate of greater than 26% would see a reduction in benefit from contributing to a 401k.
The Conclusion
As investors our primary goal is to navigate changing conditions. We will continue to stay on top of the proposed law changes, as well as the implications for investment and tax strategy. As most would expect, Biden’s tax proposals do increase taxes, which do tend to create a drag on the economy on the market. That said, it is possible that other policies would at least partially offset the economic drag from higher taxes. We will continue to keep you informed in this dynamic environment. If you would like to learn more about Biden’s tax proposals, please see: https://files.taxfoundation.org/20200928134201/Details-and-Analysis-of-Democratic-Presidential-Nominee-Joe-Bidens-Tax-Proposals-September-2020-Update.pdf
1 Tax Foundation, General Equilibrium Model, January 2020, taxfoundation.org
2 Yardeni Research