During much of 2020 and early 2021, markets have focused on fiscal policy, due to massive government efforts to help the economy speed past the impact of COVID-19 restrictions. Policy still matters, but it’ll matter far less to markets over the rest of 2021, despite some important debates going on in Washington. Markets may anticipate an increase in government spending if Congress passes some version of the Biden administration’s Build Back Better initiative, but it’ll likely be spread out over almost a decade. The biggest risk may be around taxes, with businesses and wealthy households both facing the prospect of a higher tax burden to pay for the plan, and help manage the deficit.

Federal spending unlikely to change market trajectory

Much of the approximately $5 trillion in direct COVID-related stimulus in 2020 and 2021 didn’t flow through directly as government spending. Instead, the federal government used its borrowing power to distribute funds to households and businesses. That impact will fade over the remainder of the year, but will be replaced by the private economy accelerating, which is where we would want it to be.

Actual government spending may continue to grow. However, the direct payments will likely end and the rate of growth won’t make a large difference to overall output. According to the Bureau of Economic Analysis, federal spending added an average of about 0.15% per year to GDP growth between 2000 and 2020, with defense and non-defense each contributing about half of that amount. Federal spending hasn’t contributed more than 0.5% to GDP growth since 1986. Even in 2020, it only contributed 0.29%. Stimulus was more about borrowing than government spending.

However, even a small contribution to GDP growth can be massive in absolute terms. With proposals for the two pieces of the Build Back Better plan at nearly $4 trillion — $1.8 trillion for the American Families Plan and over $2 trillion for the infrastructure bill (also known as the American Jobs Plan) — higher taxes would be needed to help finance the new spending. Let’s be clear, with a 50/50 Senate (Vice President Kamala Harris breaks ties) and the historically slim Democratic majority in the House, we think these final numbers will likely come in at $2-2.5 trillion combined, as these initial numbers from the Democrats are starting points for negotiations.

Taxes may change market path, but not direction

Federal spending is generally funded by taxes or debt, and the Biden administration plans to raise taxes to help pay for the Build Back Better initiative. President Biden has proposed increasing taxes on both corporations and wealthier households, including an increase in the capital gains tax (the tax on investment profits). Markets so far have taken the proposed changes in stride, due to expectations that the proposed tax increases will be reduced during negotiations, and that the economy will be strong enough to absorb the impact.

The Tax Cut and Jobs Act (TCJA), signed into law by former President Trump in December 2017, reduced the top tax rate on corporations from 35%, where it had been since 1993, to 21%. The top U.S. statutory corporate tax rate hadn’t been under 30% since the 1940s – prior to the TCJA. There were also other structural reforms included, such as changes to the way U.S. corporate profits from abroad are taxed in an attempt to make U.S. companies more competitive. President Biden proposed increasing the corporate tax rate to 28%. However, that should be viewed as a bargaining position. We believe the more likely outcome is that we see the rate end up closer to 25%.

The negative news for markets is that corporate earnings growth will take an approximately proportional direct hit. Since the stock market is fundamentally driven by earnings, the tax impact will likely be a headwind for equity markets. On the positive side, this move has been anticipated for quite some time and shouldn’t be much of a surprise to markets. Excluding the rate introduced by the TCJA, this will still be the lowest tax rate in about 70 years. Historically, markets have absorbed higher corporate tax rates, although with below-average returns [Figure 4]. While we don’t think higher rates would be retroactive, they could take away some of the momentum from recent upside surprises in earnings growth that we’ve seen so far in 2021, and contribute to a choppier market.

Proposed tax provisions to raise funds for Build Back Better on the household side include increasing the top tax rate on ordinary income to 39.6% from 37%, and capital gains and taxes on those who earn more than $1 million to a maximum of 43.4% from the current 23.8%.

Fun fact: Only 0.32% of the population makes more than $1 million a year. So, the truth is this won’t impact the other 99.68% of the population.

Historically speaking, capital gains taxes increased in 1986 and 2013. However, the economy was on a firm footing, compared with the 1970s hikes, which saw an economy marred by higher inflation and sluggish growth. Not surprisingly, the two more recent hikes saw solid stock market performance, while the 1970s hikes didn’t [Figure 5]. Is it as simple as how the economy is doing?

Policy matters, but broader economic trends matter more. If we see a capital gains tax increase, we do expect some investors may rotate out of equities and seek more tax-friendly opportunities — but at the cost of accelerating capital gains. Long-term investors may simply wait out the new rate, on expectations that it may be changed again by a subsequent administration.

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