Worrying About Biden’s Capital Gains Tax Headline? Don’t!

Summary

• Based on the headline, well under 1% of taxpayers could be subject to a higher capital gains tax.
• The super wealthy own roughly 10% of the equity market. Even if they sold most of their holdings before a higher tax is enacted, much of the cash would probably be reinvested in equities, offsetting any initial selloff.
• The real target here may be ‘carried interest’ income – private business income now taxed at capital gains rates. That would garner genuine populist support.

Talk about horrible headlines. President Joe Biden wants to boost the capital gains tax to 39.6% for people making more than $1 million a year, up from 20% currently. The S&P 500 promptly tanked 0.9%.

Further details are scant. There is no word yet on how progressive a new capital gains tax might be. Will it be a cliff at $1 million, or will incomes above some threshold – say $500,000 – be subject to an increasing capital gains rate? A formal proposal is expected next week.

Reality Check: Who Will Pay?

Still, the reality may be better than the headline implies. A few quick facts and figures…

Of roughly 143.3 million taxpayers, only about 0.2% of taxpayers make more than $1 million, and 1% make more than $500,000. We are talking around 236,000 and 1,432,000 people respectively.

The vast majority of taxpayers – well over 140 million – who own stocks directly or indirectly through mutual funds, pension plans, or 401K plans should be unaffected.

What might the market impact be if the top 1% bail out of stocks? According to a recent Fed survey, the top 1% holds about $28 trillion of wealth, of which about one third, or $9 trillion, is in financial assets. US equity and bond markets total about $90 trillion, with about $50 trillion in equities. The Fed provides no colour on how financial assets are invested. But if we assume a rough 50/50 split, we are talking roughly $4.5 trillion of equities that could be subject to a higher capital gain tax.

Where Will All That Cash Go?

So what if they sell before a higher capital gains tax is enacted? That would be bad for equities. But, in the highly unlikely event they sold all their equities, what are they going to do with $4.5 trillion in cash (less whatever capital gains tax they owe)? Chances are much or most of it ends up back in equities, hopefully at some higher cost basis. Bottom line, markets might be a bit choppy as selling hits, but as long as underlying fundamentals remain sound, they should soon recover.

The Real Target May Be…

In any case, chances are that the real target is not capital gains on equities.

Close to 40% of super-high earners’ wealth is actually in the form of privately owned businesses. Much of their income comes from private equity and business investments and is taxed as ‘carried interest’ rather than income. That is, it is treated as capital gains and taxed at a 15% or 20% rate instead of income that is subject to higher income tax rates.

We note that many consider this to be an egregious tax loophole. The House of Representatives is already working on a bill to address it.

Whatever else the Biden proposal does, we guess it will directly target this form of capital gains. If it does, do not be surprised if the general market reaction is a relief rally.

If the proposal focuses primarily on equities, it will probably struggle to attract 50 Democratic votes in the Senate let alone any support from Republicans. But if it addresses carried interest, it will garner populist support and maybe even bipartisan support in the Senate.

We await further details…