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Increasing the capital-gains tax rate would have little overall impact on the U.S. stock market. That’s the conclusion I gleaned from numerous academic studies and interviews with tax experts.
This conclusion is contrary to an emerging narrative that, if President Joe Biden proposes an increase in the capital-gains tax and it becomes law, “There’s going to be a stock market sell-off in some form as some rich investors take advantage of lower rates before they climb.”
Yet this narrative is not supported by an analysis of past changes in capital-gains tax rates. I was unable to find any significant correlation between increases in those rates and the stock market’s performance.
Take a look at the chart below, which plots the S&P 500’s
SPX,
total return since 1954 when the capital-gains tax has been raised. I found no pattern that is significant at the 95% confidence level that statisticians frequently use when determining if a pattern is genuine.
None of this is to deny that capital-gains taxes can have big impacts on investor behavior. But market-wide, those impacts could be largely offsetting, according to Andrew Belnap, an accounting professor at the University of Texas at Austin. In an interview, he summarized these offsetting effects as follows:
- An increase in the capital-gains tax rate will be bearish to the extent it increases investors’ required rate of return to invest in stocks. Other things being equal, that means that prices must go down.
- In contrast, a capital-gains tax hike will be bullish to the extent it induces more investors to hold rather than sell, in order to avoid incurring the tax.
Even if these two effects are not precisely offsetting, their net impact will still be small, for several reasons. One is that most stocks in the U.S. are held in accounts that are exempt from the capital-gains tax. Leonard E. Burman, a professor of Public Administration and International Affairs at Syracuse University, reports that the percentage of publicly traded U.S. stocks held in taxable accounts has dropped to under 25% from more than 80% over the past 50 years.
Another reason not to expect any significant overall impact of a higher capital-gains tax, according to Belnap: It’s not certain that any proposed increase will become law. Even if it does, there’s a distinct possibility it will be reversed whenever congressional control shifts back to the Republican Party. Given this uncertainty, he said, investors who otherwise would alter their behavior because of an imminent capital-gains tax hike may decide to instead just sit tight.
The bottom line? The relationship between capital-gains tax rate changes and the stock market is complex. But any proposed increase is unlikely to cause the market selloff that many believe will happen. That isn’t to say that the market won’t decline significantly in coming weeks and months. If it does, it will be for reasons other than taxes on capital gains.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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