I feel like each day or week, the tide turns on any spending bill that impacts our taxes, so full disclosure here: find a balance between investment prudence and reality. Easy right?

I wanted to elaborate on Sen. Joe Manchin’s spending bill comments, its effect on the market, and more importantly, what does this mean for clients regarding taxation? As you can imagine, everything that I’m talking about continues to be an evolving situation, i.e., this blog post could be obsolete within a day. So, the Date of Publication is 9/8/2021.

Senator Joseph Manchin’s Comments: Manchin stated that he would not support the Democrat’s $3.5 trillion spending bill nor support spending “anywhere near” that level. And without Manchin’s support, that $3.5 trillion bill is essentially dead, as Democrats need all 50 Senators to back it to pass.

What Does it Mean for Markets?

First, we believe it essentially eliminates any possible significant tax increases before year-end, and that’s a positive. We’ve told many of you that an increase in corporate taxes to 28% (and the initiation of Global Intangible Low-Tax Income “GILTI”) could dampen S&P 500 earnings from 7% – 9% in 2022. However, it does not eliminate the chances that we see any tax increases. The reason why is that passage of the $3.5 trillion spending bill was always unlikely. However, a smaller bill ($1.5 trillion) accompanied by small tax increases on corporations, changes in capital gains/dividends, and top earners is still entirely possible. But small tax increases on corporations (say to 25%) and the very top tax bracket, while not positive for stock prices, wouldn’t be materially adverse, either. As such, Manchin’s public declaration of non-support for the spending bill essentially eliminates the possibility the market must confront significant tax hike risks in the coming months. We believe the net effect of this is positive, as it removes a potential material risk for stocks between now and year-end, so in all, it’s a good thing (again from a market standpoint).

Capital Gains Taxation – What Does This Mean for Clients?

Reconciling everything we’ve read, our best guess is that Congress could raise the top tax rate on capital gains from 20% to around 28%, and the higher rate could be initiated sometime before year-end. The first question is whether a bill raising taxes will become law. Democrats took a big step in that direction in August by passing a budget resolution through the House. With both chambers having passed a joint budget resolution, Democrats now can write a budget package, including tax provisions, that can pass the Senate with 51 votes.

If a bill is passed in 2021, it could include higher taxes on capital gains and dividends. On the original $3.5T bill, President Biden proposed taxing capital gains and dividends for those who earn more than a million dollars as ordinary income. Still, some Democrats have come out publicly in opposition to the idea. There is also considerable opposition to getting rid of step-up in basis. We believe that provision is likely to drop with modest estate tax changes (higher rate, lower exemption) somewhat possible as a substitute.

Democrats in Congress will likely agree to raise the capital gains and dividend rates from 20% today to around 28% for those making more than one million dollars (or perhaps something as low as $400,000). There is also a 3.8% tax on investment income on those earning more than $250,000 (joint filers), so the combined capital gains rate would total close to 32%. Why 28%? Well, simply put, there have been multiple studies showing that the capital gains tax equilibrium is 28% – meaning that if capital gains tax were above 28%, the government would bring in less money, as fewer people would realize gains.

What about an Effective Date?

At the onset of the bill, President Biden stated that the Capital Gains Tax would be retroactive. The retroactive statement is Biden putting a stake in the ground to jawbone companies not to issue special dividends and investors not to realize gains before Congress passes legislation. But we sense that if a tax increase passes later this year, the timing of the tax increase will be closer to the date of enactment, even if the change is (slightly) retroactive. Historically speaking, given the logistical difficulties, Cap. Gains taxes have never been fully retroactive:

President Biden’s budget proposed that the effective date be when he outlined his tax increase in the Spring. The effective date that seems most consistent with Democratic priorities, but not gratuitously punitive, would be the date of introduction of the tax legislation by the Ways and Means Committee chairman, which could range from early to late September. The Senate Finance and House Ways and Means Committees (and other committees) have a September 15 deadline (it’s a soft deadline) to pass reconciliation legislation out of their respective committees. Ways and Means are scheduled to mark up the bill about a week before, but we have our doubts they can meet this schedule. Another possible effective date could be when the bill is signed into law, probably October or November. It is also possible the effective date could be January 1, 2022, especially if Democrats aren’t able to pass a tax bill until late in the year.

The other tax increases likely to be included in the reconciliation bill are very likely to be prospective, and for the most part, they probably won’t be phased in. Higher tax rates on corporations, dividends, and individual income are likely to effect on January 1, 2022.

What are the Chances of a Tax Increase in 2022?

Well, betting odds put it at a pretty good chance:

Overview:

We do not know precisely when all of this could be instituted, nor can we predict the impact on the markets. The above information is just what we have been reading, as this topic continues to be an evolving matter and will continue to change. Though, a worry of mine is that investors can make the mistake of letting the tax tail wag the investment dog. It’s common for people to make the mistake of being so focused on either minimizing or avoiding taxes that they end up making decisions that compromise their investment portfolio. We do our best to make sure that is not the case.

We are very aware of this developing situation and will do our best to help you navigate this process. As always, feel free to reach out if you have a question.

Source: Aptus Capital Advisors, Stategas, CSM