Roger Montgomery asks, could Biden’s latest pronouncement spell the end of the Bull Market?
24 April 2021 | Roger Montgomery
Tax is a very powerful driver of behaviour. For local evidence we only need to look at Australian property prices. While long-term, immigration drives property prices, and in the shorter-term access to credit, these influences occur under the umbrella of very favourable tax conditions combined with the willingness of banks, regulators and the government to allow buyers to use massive amounts of leverage to purchase their main residence.
Since capital gains tax commenced on 20 September 1985, all assets acquired are subject to CGT, unless specifically excluded such as a main residence.
Without tax free capital gains for homeowners, the property asset class may not have evolved into one the entire financial system is now dependent on.
But the influence of tax on investment decision making isn’t limited to Australian property. Industry-level data from a set of OECD countries shows business investment responds negatively to an increase in the corporate tax rate and to a decrease in capital depreciation allowances through changes in the user cost of capital. Meanwhile, tax incentives for research and development (R&D) are found to have a positive effect.
And in their 1967 article Tax Policy and Investment Behavior, for The American Economic Review, Robert Hall and Dale Jorgenson noted the belief that “businessmen in pursuit of gain will find the purchase of capital good more attractive if they cost less.”
And in her 2008 OECD Economics Department Working Paper No. 656 entitled, How do Taxes Affect Investment and Productivity? An Industry-Level Analysis of OECD Countries, Laura Vartia concluded; “The findings of this paper suggest that taxes have an adverse effect on industry-level investment. In particular, corporate taxes reduce investment by increasing the user cost of capital.”
One can reasonably presume that ‘industry-level investment’ is driven by people. Those same people also make personal investment decisions.
And that’s perhaps where we should introduce US President Biden’s recent comments.
The Biden Administration is proposing to nearly double US capital gains taxes to 39.6 per cent from the current rate of 20 per cent! Specifically, this would apply to people earning more than $1 million a year.
If the cost of capital has risen materially for investors in currently profitless companies – those with profits pushed out in the distant future – the present value calculation hits these company valuations the hardest.
The high growth end of the market could, in theory, be very hard hit.
While the proposal will help pay for an education and child care package, which of course makes sense, wealthy investors, in anticipation of higher capital gains taxes may be incentivised to take their profits early. That means selling now in advance of the changes and it could have the effect of permanently shifting the appropriate PE ratio to pay for every investment.
Perhaps unsurprisingly, news sparked a sell-off in the Dow Jones Industrial Average overnight. But it’s only early days. There’s a lot of legislation to be written and a phalanx of vested interests to navigate.
I have however learned that investors often freeze in the headlights of a crisis. I wonder whether we will see the same thing now. Probabilities of success will be applied by investors to any legislation that introduces the tax increases, and they may yet be watered down. But if Biden’s full promises were to be implemented, the influence must be negative on stocks, private equity investments and any other assets to which the changes apply.
Typically, those stocks in which inhere the largest capital gains – think tech et al would be the first cabs off the rank.
We know that tax affects behaviour materially so this news could yet be a much bigger story. It’s therefore one to watch very closely.
Roger Montgomery is the Founder and Chief Investment Officer of Montgomery Investment Management which has A$1.44 billion in funds under management.
DISCLAIMER: This article is for general information only and does not consider the circumstances of any individual.