It was announced last week in a report by Bloomberg that President Biden is planning to increase the capital gains tax rate on those with earnings of $1 million or more. This increase would be introduced as a way to fund the American Families Plan, a bill that would expand child care benefits and provide free community college along with several other initiatives. For earners in the top tax bracket this would almost be double what the current capital gains tax is, going from 23.8% to 43.4%. Anyone with sizeable capital gains will be facing a fairly large increase to their tax bill, regardless of their tax bracket.
I want to clarify that this is not confirmed yet. It also would have to be passed in Congress where it could face some challenges. This would be the largest capital gains tax increase ever, so it is unlikely that it would be passed in its entirety. A more plausible outcome is that we will see a top capital gains tax rate closer to 28%. Regardless, what would a scenario for the markets look like should an increase in the capital gains tax rate occur?
Logically, it would make sense that an increase in capital gains would hurt the activity in capital markets. The more expensive investing becomes, the less compelling it is for market participants to invest. You would think this would therefore hurt the returns in investment markets. Well, surprisingly this chart put together by FactSet and UBS shows otherwise. It shows years when the capital gains tax rate was changed and the subsequent return of the S&P 500. The main takeaway is that changes to the capital gains tax have almost no correlation to subsequent returns for the S&P 500. Most recently, you can see in 2013 the capital gains tax rate was increased by almost 10%, but the S&P 500 went on to make a 30% return that year. On the other end, when capital gains tax rates were cut in 1981, the S&P 500 went on to lose 10%. You can observe from the chart that the S&P 500 has posted positive and negative returns when the capital gains rate was increased, and it has posted positive and negative returns when the capital gains rate was decreased. A capital gains tax rate increase does not appear to be something investors should be fearful of.
This isn’t to say there aren’t any risks present in markets today. There are plenty of risks on the horizon, but an increase in the capital gains tax rate doesn’t appear likely to be one of them.
