- Tax increases may not be the obstacle that many investors expect.
- Typically, there is sizable federal spending as an offset.
- The stock market has the potential to see past the tax increases because of so many other economic factors.
Elections and your money
Nobody can tell you for sure what is going to happen to taxes in the US after the 2020 election, but we can look at how the stock market has reacted to past significant changes to the tax code, going back to 1950. Despite the assumption many have that increasing tax rates would sink stocks, markets have produced better than average returns in the wake of changes because of other economic factors happening at the same time to influence subsequent market behavior.
"There is never 'one thing' for the market,” says Fidelity sector strategist Denise Chisholm. "There are too many moving parts to hold all else equal."
A look back
Taxes break down into 3 basic baskets: corporate, personal, and capital gains. Big increases are rare, only happening about 10% of the time over 70 years, amounting to just 23 instances among the 3 types. The last time all 3 kinds of taxes increased at the same time was 1993, followed by an increase in personal taxes and capital gains taxes in 2013.
Rates have been cut since then, through the Tax Cuts and Jobs Act, which went into effect in 2018. The top corporate tax rate is now 21%, the top personal rate is 37%, and the top long-term capital gains rate is 20%.
The rates will sunset in 2026 and return to what they were previously if Congress does not make changes sooner: top rates of 35% for corporate taxes, 39.6% for personal taxes, and still 20% for long-term capital gains. The 2020 election will be a key indicator, depending on who wins the presidency and which parties control Congress.
"We would expect a Democratic tax plan to revisit the Tax Cuts and Jobs Act, and that could mean a higher corporate tax rate and increased marginal rates for higher income earners, as well as higher investment tax rates for capital gains and dividends," says Jim Febeo, senior vice president, head of federal government relations at Fidelity.
What does history say? In the 13 previous instances of tax increases since 1950, the S&P 500, the stock index that tracks most of the major companies in the US, has shown higher average returns, and higher odds of an advance, in times when taxes are increasing, according to Chisholm's research, which analyzed the data in the calendar year of the tax changes, plus the year prior and year after. This holds true even when you drill down into key sectors of the S&P 500.
"Economically sensitive sectors, like consumer discretionary, oddly have done better during years taxes increase. These counterintuitive odds suggest something else is going on—the market either discounts it in advance or the economy has received stimulus to offset it," says Chisholm.
The research shows that bonds have also followed this counterintuitive trend. You might expect bonds to benefit from the obstacle of a tax increase, because investors become more defensive or the economy softens in response to the tax increases. But, in fact, they tend to struggle. While historically, high-yield bonds tend to do better, investment-grade, government, and municipal bonds have struggled in relative performance. While correlation isn't necessarily causation, inflation did have a higher tendency to accelerate during years that taxes rose, potentially the result of fiscal stimulus at the same time.
What else factors in?
Changes to the US tax code don't happen in a vacuum. There's usually a lot of other action going on in Congress and the economy in general, because there is an economic need driving all the actions. There's typically significant stimulus spending by the government, either in defense, infrastructure, or social welfare, as well as action from the Federal Reserve to curb inflation by raising rates.
"The stimulus is perhaps the critical factor that may be the reason for the higher than average returns—that is something investors really need to keep their eye on," says Chisholm.
What this might mean for today
Past performance is no guarantee of future results, of course. Our current economic situation, compounded by COVID-19, is different than any situation we've faced since the 1950s.
"There are all sorts of things you can throw into the analysis about how different it's going to be this time and I get that, but it's very interesting to look at the fact that 100% of the time corporate taxes were raised equities advanced the year prior and the year during," says Chisholm.
So beware of knee-jerk assumptions that tax increases necessarily mean down markets for stocks. For investors, it's important to have a plan you trust and can stick with, no matter what happens in the short term with stock markets. You can talk to a professional to find a suitable approach for your own investing needs.