How Biden’s Capital Gains Reform Will Affect Stocks
In terms of the leading Democratic presidential candidates, Joe Biden clearly appears to be the least damaging to the stock market, but this does not mean there won’t be any.
Compared to the impact of wealth taxes, raising the capital gains tax on those whose income is $1 million or more would certainly be low-impact on the stock market, and we might not even think that this would be that meaningful or perhaps not even at all.
Wealth taxes of any amount will involve positions being sold off to pay the tax, and among the effects of this would be to create considerably more selling pressure on stocks and may even cause a very long bear market by itself.
Stocks go up in price to a large degree because people put more money into them than they take out, but if some very large shareholders have to sell a lot of shares each year to pay their tax bill, that will end up to quite a bit of extra selling pressure.
Some have predicted a massive late year sell-off from a wealth tax, and if this actually happened this would present some sure-fire opportunities on the short side we would think, but the premium for shares would be unlike anything we’ve ever seen and these premiums would probably make a lot more money for brokerages than individuals.
People or institutions don’t just dump shares at once though so it’s more likely that this would have to be spread out over a lot longer time than just the last few days or even weeks and we’d probably see shares being dumped throughout the year to handle this.
Even the more modest wealth tax of Warren would place a big burden on stock prices because those who are subject to this wealth tax hold a lot of shares and would have to sell a lot each year. This would cut them down a notch but end up cutting everyday investors down a notch as well, even to the point of ruining their retirement plans.
It won’t really bother politicians like Warren and Sanders that a wealth tax is double taxation, because the goal here isn’t fairness, it’s making the very wealthy pay more, but we cannot ignore what this will do to the stock market and to those who have their life savings in it and are hoping to be able to retire in a somewhat comfortable manner.
It’s easier to just shoot off your gun and not think about who is going to end up on the other end of your bullets, and these bullets will hit everyone. What makes this scenario so dangerous is that someone with a gun may be discharging it in this manner soon, or at least hope to use it this way if Congress buys the bullets for them.
The marginal effect upon everyday investors will be much greater with than with the ultra-wealthy whose lives aren’t going to be materially changed very much, but a lot of much more modestly well-off people can’t afford to give up the expected gains of their investments, and especially cannot endure the big losses of their principal that a wealth tax could result in.
Joe Biden Puts the Stock Market in Jeopardy with His Capital Gains Tax Increase
Joe Biden isn’t planning a wealth tax, but he is planning on doubling the capital gains tax for those who earn over $1 million a year. This might not seem like a big deal at all if we just look at the situation superficially, but this also poses a threat of its own to the stock market.
The real problem here isn’t the tax itself, it’s how we treat gains from selling stocks. Providing preferential treatment for capital gains, including the sale of shares, is supposed to encourage investment. With stocks, since holding stocks isn’t actual investment even though we call it that, having more or less money invested in them doesn’t really have any bearing on the economy, as it is neutral in this regard, but it sure does help or hurt people looking to save money and build their wealth.
It we are actually looking to narrow the wealth gap between the top 0.1% of people and the other 99.9%, and our chosen course of action is looking to take away a good amount of the wealth of the upper echelon, we need to avoid putting down the wealth of the rest of us, and that’s a lot harder to do than it may seem. We may think that those who make $1 million or more can afford to pay more tax and can handle it pretty comfortably, but this alone does not mean that we should want them to.
If we structured capital gains to better serve its ultimate purpose, to put more money in the hands of everyday investors, we could even take this tax break away from those who earn this much a year and be pretty comfortable doing it, but not the way that capital gains are applied under the current system.
What we want to be doing here is allowing people to invest without incurring tax liabilities along the way, where taxes are due when you withdraw funds for some other purpose. We already do this with retirement accounts and it makes sense to do it this way even though the government would benefit by taxing us every step of the way.
The government has been kind enough to only tax us on our traditional 401(k) and IRA savings when we take out the money, and don’t charge us tax at all on our accumulated returns on the Roth versions of these retirement plans. This is done to help us save, but there’s another important thing that this accomplishes, and that’s to avoid us having to pull money out of our investment accounts to pay taxes along the way.
We do tax non-retirement investment accounts though, and this does result in a lot of money taken out of the market already. When we put up the capital gains tax rate, this means that even more money will be taken out of the stock market to pay this tax, and people who earn a million dollars or more a year hold a lot of stocks and pay a lot of tax on their returns. When we double this, that’s a lot more money taken out of the market.
As it turns out, people generally have enough trouble saving up for retirement, and few actually take advantage of their maximum contribution limits, so the vast majority of their investment money goes into these retirement accounts. This is different with the very wealthy and especially among high-income earners, over a million a year, and these are the people who have more to invest than just what they can put in their 401(k)s or IRAs and therefore will see their portfolios hurt quite a bit by this.
Some will claim that all we have to do is keep our stocks until we need the money to avoid this, and that part is true, but this takes us off the path and sometimes far off the path of optimal investing and even sensible investing. Stocks don’t always go up and they often go the other way, and while saving tax matters, holding a stock that you otherwise should not can cost you a lot more.
Few investors think very much of these things or would know what even striving for optimal investing would mean, so we need to start by explaining to people properly what this does involve. We invest in stocks with a positive expectation, and therefore when they do not have a positive expectation over an actionable time period, and we stay in them, this is always a mistake.
It is the typical investors who are more prone to act this way though, to ignore risk basically and even ignore the reason why they are investing in the first place, but this is considerably less the case with the very rich. Ordinary investors manage their own investments typically without much of an idea of what they are doing, but wealthy investors have the means to hire others who at least know more, and would therefore be less prone to making stupid mistakes.
This is not to say that their advisors don’t make them, they just tend to make less of them, and therefore they will turn over their positions more often than average and also incur these capital gains more often. When we double the amount of tax that they are paying, this is going to result in their taking twice as much money out of the market, and it still is going to make sense to exit some of these positions even with paying more tax up front on the gains.
If you are in a position that has a negative expectancy, and that your expected losses exceed any tax benefits, it would also be stupid to hang on to the positions. Stocks can move a lot and it doesn’t take that much to overwhelm the tax benefits of holding on and being forced into a position where you have to bear the additional losses.
We Need a More Sensible Approach to Capital Gains Taxation
The rationale with deferring the tax is that by paying it now you are forsaking returns on the money you pay in tax now, but if that money is sitting in a stock with a negative expectation, you are not only not missing out on profit but are also subject to losing principal. The tax benefits of holding here is therefore a façade no matter how high the tax rate goes to. Even if it were 90%, you’d have to pay it regardless, but if you wait and your 10% adds up to less later, you have acted unwisely.
When you have taxes due, this also means that you will commit less to re-investing because the IRS is taking their cut now. If we raise that to almost 40%, they will take an even bigger cut, and take out twice as much money out of the stock market instead of seeing it re-invested in other stock positions.
This will hurt on two different fronts, and both have their price. This will surely cause these bigger investors to think twice in a lot of instances, and even think twice when they are better off just paying the tax, because people aren’t going to be doing much math here. Paying tax is in itself seen as a bad thing and that alone can cause people to do the wrong thing financially just to avoid it, without properly considering the alternative.
Holding on to the stocks and taking whatever punishment that comes isn’t the big issue here, and this will hurt the wealthy in the end but that’s the plan here. This won’t put a stop to the outflows because even with doubling this tax there are going to be a lot of situations where it still makes sense to do it, and this will indeed cause a significant amount of money to be taken out of the market and cause stock prices to suffer as a result.
If we want to tax very high earners like this, it’s just better not to screw up the stock market or even risk doing this, because then everyone suffers, right down to Mom and Pop who just want to live out their final years with enough to pay the bills.
We could even double the capital gains tax on the wealthy without any real repercussions to the stock market at least, even though the economy may be a different story, by making taxes payable when the money is withdrawn not just with retirement accounts, but with all individual investment accounts.
What we need to avoid here is either incenting people to make what would otherwise be mistakes by their holding stocks past their time, as well as preventing the downward price pressure on stocks when they can only re-invest a portion of their profits, where the rest needs to be handed over to the IRS. There needs to be a better option.
If money is being withdrawn, then the taxes are no longer competing with re-investment and at least there wouldn’t be an effect upon stock prices. Just because you hold shares in one company rather than another should not trigger taxation, although we do so out of convenience perhaps as well as due to not thinking about this enough.
If we really want to help people save, apart from the tax reform that retirement accounts have provided us, we should take at least one aspect of these plans, when taxes are triggered, and apply it to more than IRAs and 401(k)s. By doing so, we will ultimately be raising everyone’s boat by not having the government take a lot of money out of the stock market where it would be to everyone’s benefit for them to refrain from this, and only do so when the money actually comes out of the stock market by choice.
If we can ever manage this, we could double the capital gains tax like Biden wants to do for the higher income people and it not hurt stocks. Biden probably has little idea of how this would, and it’s not likely he will even as president, even after it happens. He may even take a lot of the blame in the end, but he probably won’t be that sure why he is to blame.
This will have a positive influence on the well-being of all investors because the limitation of having to sell to pay tax goes on to some extent and damages the long-term returns of everyone. We see what happens when companies buy back shares, but taxes cause them to be sold off and this does limit stock prices. Making this negative effect considerably worse does not advance anyone’s situation and does the opposite.
This is just one of many bearish influencers that having a Democratic candidate winning the presidency would bring to the stock market, but this is one that very few people realize, and therein lies the real danger.
Most of their proposals would not stand a chance to make it through Congress, but this one has a much better chance and therefore may be the one that needs to be feared the most if you are invested in the stock market.
Being completely out of stocks at this point may be the only sensible approach if Biden or any Democrat wins the presidency, although if we don’t realize the extent of the threat, we will not be prepared enough. The election is still over a year away, but it’s not too soon to start thinking about what we will do if this happens.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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