Preparing for Higher Tax Rates

5/18/21: Tax rates will soon be on the rise. We heard about it on the campaign trail, and so it should not come as a surprise that we are hearing about it again now. President Biden will unveil his “American Families Plan” Wednesday evening in his first speech to a joint session of Congress. The $1.5 trillion “human infrastructure” program, which represents the biggest expansion of federal support for lower-income and middle-class Americans in decades, would be largely paid for by a series of tax increases on the wealthy, according to administration officials. The plan calls for Americans earning over $400,000 to face higher marginal income tax rates. Those earning over $1 million will be hit with a 43.4 per cent capital gains tax, more than double the current rate. Jimmy Carter was president the last time the tax rate on capital gains was this high.

According to Democrats, the plan – which taxes the wealthy to aid the poor and middle-class – is an attempt to address long-standing income and wealth inequality. The proposal reverses a long-standing tax code philosophy that treats returns on investment more favorably than labor income (wages). Biden campaigned on raising capital gains and income tax rates on wealthy individuals, believing it is unfair to allow them to be subject to lower rates than their employees. Warren Buffett, back in 2013 when the rate was raised to 20 per cent from 15 per cent, had asserted that the capital gains rate was eight or nine points too low. The Biden administration, in an effort to better balance capital and labor, could also raise the tax rate on dividends, which is currently pegged at 20 per cent. Biden is also expected to eliminate the carried-interest loophole, which treats fund managers’ partnership income as capital gains rather than ordinary income. That’s in addition to the higher corporate tax rate plan unveiled last month. A recent New York Times report estimates that taxing carried interest as ordinary income would raise about $180 billion.

Thanks to last minute modifications, the biggest potential tax impact from the President’s myriad proposals would have come from the elimination of the step-up in cost basis on inherited assets at death. That measure considered a step too far, even among Democratic circles, has been rumored to have been removed.  In many respects, capital gains taxes are voluntary, requiring the investor to sell an appreciated asset.  Elimination of the step-up at death would making paying the capital gains tax unavoidable, forcing heirs to shell out taxes on any gains above their original cost. Proponents argue that eliminating the step up at death targets dynastic wealth and inequality. From a practical perspective such a tax could force the liquidation of closely held family businesses. Besides, determining a proper market value could be nearly impossible in certain circumstances. Historically, invested capital has grown much faster than labor income. Since 1978, household income has grown by 320 per cent, slightly outpacing inflation. Over than same period, capital – as represented by the S&P 500 – has expanded by 10,259 per cent.

Biden will be presenting his “American Families Plan” to a receptive populace. The pandemic accelerated a trend toward Americans worrying less about gaping deficits and rising debt and more about what the government can do to help its citizens. Recent polling data suggest Americans welcome a more active government. A Gallup poll conducted in September 2020 showed 54 per cent of American respondents believe the “government should do more,” versus 41 per cent who believe the “government is doing too much.” The results are striking on two fronts: it’s the first time since 2001 that more Americans want the government to do more; and even more important, it’s the largest share of Americans in favor of a more active government in this survey’s history back to the early 1990s. The results are consistent with the country’s overwhelming support for the more than $5 trillion spent for three budget-busting COVID-19 relief bills over the last year or so. Biden is also riding on a relatively strong approval rating, with 53 per cent currently in support of his job performance, according to a Washington Post/NBC survey. The stage is set for bold initiatives.

Meanwhile, the Republican opposition is struggling with a credibility problem. The party is having a difficult time reigning in the proposed spending programs by taking the high ground on fiscal responsibility. That’s because of the Trump administration’s fiscal track record. It steered billions of dollars to the agricultural sector, which had been hit hard by the US-China trade war on top of an estimated $1.6 trillion hike in national debt from President Trump’s 2017 landmark corporate tax rollback. Cumulatively, Trump racked up a $5.1 trillion deficit during his time in office.

President Biden’s proposed 39.6 per cent rate on long-term capital gains is punitive and likely sub-optimal. Congress’s Joint Committee on Taxation calculated the revenue-maximizing capital gains rate at 28 per cent. We therefore conclude it is designed to punish the wealthy, even if that means leaving tax revenue on the table. Even Mr. Magnanimous Warren Buffett likely believes a nearly 40 per cent capital gains tax is too high. This is an opening salvo: we expect the agreed rate to settle around 28 per cent, halfway between the current 20 per cent and the 39.6 per cent rate under consideration. On top of this the current 3.8 per cent tax on investment income that funds the Affordable Care Act would still be applied. We could also possibly see the tax rate on dividends raised to 28 per cent from its current 20 per cent rate, although we haven’t heard talk of that yet.

Despite the dire warnings, we believe the market impact of a higher capital gains rate would be minimal since only about one-quarter of today’s equity market holders are subject to capital gains taxes. That’s because 40 per cent of US equity holders are foreign and another 30 per cent are tax-exempt pension funds and retirement accounts. We believe it is unlikely that affected equity holders would simply cash out to realize gains and then run away from the equity market. Given that the capital gains tax applies to investments of all stripes, from equities to art, affected investors would most likely sell and rebuy similar securities to boost their cost basis. Besides, any significant pullback would be pounced on by opportunistic buyers who are unaffected by the new tax regime.

When President Reagan signed the Tax Reform Act of 1986, he lowered the top income-tax rate from 50 per cent to 28 per cent, while raising the capital gains rate to 28 per cent from 15 per cent. When the bill was passed by Congress in October1986, the news prompted a sharp rise in sales of all capital assets, according to the Tax Policy Center. The S&P 500 plunged 8.3 per cent in September. By December, however, the market had fully recovered. Reagan’s tax package was offset by free market incentives, including a rollback in regulations, the weakening of labor unions and globalization, setting off decades of profit growth which dwarfed labor income gains. That trend peaked in 2011 and has been steadily in retrograde ever since.

In anticipation of a higher capital gains tax rate next year, investors could realize capital gains now at the prevailing 20 per cent rate, since it would be unlikely that any increases enacted would be retroactive to today. Our calculations suggest the “sell now” strategy makes sense, even at a lower anticipated 28 per cent capital gain rate. We ran a simple scenario comparing two, million-dollar portfolios with cost bases of $500,000 as of 2021, equating to an after-tax value of $900,000 at a 20 per cent rate. Portfolio #1 realizes the capital gain this year and begins 2022 with a portfolio worth $900,000. Portfolio #2 does nothing and begins 2022 with a $1,000,000 portfolio. Both portfolios grow at a 5 per cent annual rate over the next decade. While the market value of Portfolio #2 consistently exceeds that of Portfolio #1, the after-tax value of Portfolio #1 remains above that of Portfolio #2 over the next 10 years. This example assumes, however, that future capital gains taxes will remain at the new, higher rate. If, for example, an investor’s income drops below $1 million, under Biden’s current plan the capital gains rate, would revert to 20 per cent, making the “hold” strategy a better choice. High income earners should realize capital gains in years when their income slips below $1 million to take advantage of the relatively lower rate

Taxable income could be reduced by shifting assets into tax-exempt municipal bonds and making charitable contributions, with appreciated assets of course. Investors recognizing capital gains this year should consider rolling their gain into a qualified opportunity zone strategy. QOZs help defer capital gain recognition and are a great tax-advantaged way to own real estate.

We recognize tax situations are varied as body types, facial expressions and hairlines. Talk to your Cresset advisor to plan the best strategy for you and your family.