What was proposed?
President Biden announced a detailed set of new proposals at a joint session of Congress on April 28th.
These proposals purport to do a lot of things, including:
- Free community/public college
- Universal preschool
- Increasing paid family and medical leave
- Extension of child tax cuts
- Increase in teacher education programs
- Extensive child care tax credits
- Expanded school lunch programs, supplemental nutrition assistance (food stamps)
- Expansion of IRS, increase frequency of audits
While the final form these proposals will take is far from certain, we know many of our clients are concerned about the possibility of their tax liability increasing. It does seem that some taxes will go up, particularly for the highest earning families with the most assets. While no one likes paying more taxes, we think these proposals are at least unlikely to have a systemic effect on financial markets. Read on for more details and our Telarray perspective.
How will it be funded?
With any such broad proposals, there are usually new taxes suggested to cover the cost. This time is no different. There were three definitive proposals mentioned in the speech:
- Top tax bracket for ordinary income back to 39.6% from the current 37% (plus 3.8% Medicare tax), which generally affects couples with income greater than $400,000.
- A capital gains rate switch to ordinary income (39.6% plus 3.8%) for those earning income (AGI) over $1MM.
- It is possible that large estates could be in double jeopardy. They appear to be subject to both the current estate tax but also the new capital gains tax on unrealized appreciation upon death. The interplay of these tax provisions is not very clear at present.
More detail on proposed estate tax changes:
- For a married couple, the first $2.5MM of capital gains are not taxed upon death.
- The estate tax lifetime exemption is expected to remain at approximately $12MM (single) and approximately $24MM (couple) until 2025.
- So, for a married couple, estates below $2.5MM would apparently not have an estate tax or the new capital gains tax upon death.
For estates of married couples from $2.5MM up to $24MM, they would apparently have no estate tax, but would have the new capital gains tax upon death. The rate on the capital gains tax is very likely to hit the new 43.4% rate since it is very likely for income to be in excess of $1MM from the gains in estates of this size. The current estate tax rate is 40%, so at first it seems that the capital gains tax is more expensive (43.4%). The capital gains tax should turn out to be less expensive since the capital gains tax is calculated only on capital gains instead of the full value of the assets. Biden mentioned that he dropped the expansion of the estate tax but looking at it closer seems to make his statement disingenuous. First, expansion was already scheduled with the expiration of the higher lifetime exemption, dropping from approximately $24MM to $12MM. But also adding an additional new capital gains tax that is due upon death sure seems like an expansion of the estate tax even if it is named a capital gains tax!
For estates of married couples in excess of $24MM they would apparently have both the estate tax and the new capital gains tax upon death. We have not seen any indication of the interplay of how these two taxes are to be implemented, but obviously it comes pretty close to double taxation on the same event, the death of a taxpayer. We certainly hope the final changes are not nearly this draconian.
Our interpretation:
There is no way to conduct detailed analysis of any of these proposals, since there is no official, concrete proposal to comment upon. With that said, here are a few points:
- Most of the income-based taxes are for high earners, phasing in somewhere between $400k and $1MM of income.
- As far as the estate-related proposals, there is just not much to do right now but wait and see how things develop. These proposals almost certainly won’t make it through exactly as proposed. If they are passed, they are likely to be watered down to some extent.
Biden Tax Proposal FAQs
How does the proposed top income tax rate compare to historical rates? How will that affect markets?
As you can see in the chart below, income tax rates have varied widely over time. The highest tax rate in the Biden proposal will only go up a few percent. That rate is relatively low by historical standards, though painful if you must pay it. Looking at the chart below, the rate proposed of 39.6% + 3.8% is still modest by historical rates. We have seen much worse even in the last few decades.
Keep in mind that though marginal tax rates used to be higher, there were many more deductions to keep the effective tax rates lower. One of many examples is that credit card interest was deductible until the 1980s- hard to imagine that deduction today.
With that said, the increase being proposed is small enough and scope narrow enough that it is unlikely to have a significant effect on the economy or markets.
How does the capital gains rate compare historically? How will a rise affect markets?
The capital gains rate moving to 39.6% plus 3.8% is relatively high by historical standards, in fact, it has never been so high. It does only apply for high earners (over $1MM AGI). For those caught up by this tax (if implemented), it will likely reduce portfolio turnover and change financial plans, depending on what happens to the estate tax as well.
The capital gains tax is the one most likely to affect markets since higher capital gains could make stock ownership less attractive. Will higher capital gains hurt equity markets? We have had rising and falling capital gains rates throughout the 20th century, and this chart from Bloomberg shows that historically even in the face of rising cap gain rates the market has done well:
How does the estate tax compare historically?
The estate tax rate does not matter for most people as much as the estate tax exclusion, which is currently around $12MM and for a married couple almost $24MM. That means only the largest estates even must worry about estate taxes, currently. There is some talk about increasing the rate from currently 40% to maybe 50%. Currently the estate tax applies to a small section of the population, but any move to lower the exclusion will catch many more taxpayers in the net.
Already the exclusion is scheduled to fall to approximately $6MM ($12MM married) in 2025, and any further drop will impact a lot more Americans. Like any tax problem, there are always best practices to deal with it, and we will be ready to help more clients if lower exclusions come about, just as we do with our largest clients now.
You can see in the chart, the estate tax has varied significantly, and even a rise to 50% would keep it well under the long-term average.
Top estate tax rate over time:
How does the corporate tax rate compare historically? Will it affect the market if it rises?
The corporate tax rate is relatively low by historical standards, but the US has relatively high corporate tax rates compared to the rest of the world. Corporate rates were lowered from 35% to 21% under Trump’s watch, and Biden is proposing they go back up to 28%. This could influence markets, but any significant adverse impact would likely be mitigated by the continuing economic recovery.
The corporate tax rate is somewhat controversial, since ultimately companies are owned by people, so a corporate tax of any sort represents double taxation (particularly when it comes to dividend payments). Nevertheless, raising the corporate tax is always a priority among certain factions of our elected officials, and will likely continue to be a recurring proposal in the future.
In the chart you can see that even at a rate of 28% the corporate tax rate would still be low compared to historical precedent.
Conclusion
Very little about the trajectory of future taxes is known with certainty at this time. The purpose of this message is to inform you about the proposals currently afoot, and also to give some historical perspective. Even if these taxes are passed, it looks like they will still be below the long-term average tax rates.
Nobody likes paying more taxes, but at least there is historical precedent that they may not have a systemic effect on financial markets. Tax rates have been higher at different times and did not crash the economy.
Most importantly, we want you to know that Telarray takes these proposals very seriously. We will continue to monitor the proposals and develop best practices to help secure your financial future.
