History lessons from past tax hikes

Higher rates may not tank the stock market the way investors expect.

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Key takeaways

  • 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 tax increases because of other economic factors.

There are still many miles to go before we see any tax hikes under the Biden administration, 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 that 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."

Taxes and stocks: 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 outcome of the 2020 election set the stage for many changes, but because the Democrats have slim margins in both houses of Congress, it's unclear how much of Biden's campaign tax agenda will make it from proposal into law.

"The greatest alignment for increases among Democrats is to raise the corporate tax rate and the individual marginal rates for the highest income earners making over $400,000, as well as investment taxes and the treatment of capital gains at death," says Jim Febeo, senior vice president, head of federal government relations at Fidelity. "Anything that passes is likely to be through a budget reconciliation process, requiring a simple majority vote, but also meaning any proposed hikes will require unanimity among Democrats. It will take some time for Congress to negotiate a major package, meaning you probably won't see new rates take effect until tax year 2022, though capital gains and dividend rate changes could go into effect sooner."

What does history say? In the 13 previous instances of tax increases just 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 pattern 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 the increase 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.

Beyond taxes: 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 tax hikes might mean for investors 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.

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