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How Tax Policy Affects the Stock Market and Economy Thumbnail

How Tax Policy Affects the Stock Market and Economy

As Benjamin Franklin famously said, “In this world, nothing is certain except death and taxes.” Taxes are no one’s favorite topic, but their importance cannot be overstated as tax policy affects every aspect of our financial lives including how much of our paychecks, investment gains, and dividends we keep. 

Further, taxes affect our choices of retirement vehicles, estate planning considerations, insurance and asset protection strategies, and much more. This is why tax planning with the help of a trusted financial advisor is essential to best achieve our financial goals.

Naturally, some investors also worry about how changes to tax policy will impact the stock market. This is especially true during a presidential election year since taxes and government spending are politically charged topics. History shows, however, that while taxes might impact specific industries or asset classes, they have not been the main driver of bull or bear markets. 

In this context, there are three key facts investors should keep in mind when it comes to their investment decisions.

Individual tax rates are historically low

First, although the history of taxes is complex, it’s fair to say that individual tax rates have been much higher in the past. For instance, the accompanying chart shows that during the 1950s and early 1960s after World War II, the highest rate was a staggering 91%. 

The Tax Reduction Act, proposed by President Kennedy and signed into law by President Johnson in 1964, cut federal income taxes by around 20 percentage points across the board, bringing the top marginal rate down to 70%. The bill also reduced the corporate tax rate from 52% to 48%.

Ronald Reagan was then elected in 1980 on a platform of lower taxes and reduced government spending and regulation. Over his two terms in office, the top marginal rate fell from 70% to 28%. This was an era of stagflation and both fiscal and monetary policy sought to stimulate the economy while reigning in supply problems due to high food and oil prices.

 Since then, changes to marginal tax rates have been minor by comparison. For instance, President Trump signed the Tax Cuts and Jobs Act in 2017, which lowered the top individual income tax rate from 39.6% to 37% for households earning more than $600,000 and doubled the amount households can pass tax-free to their heirs.

There have been countless other changes to the tax code, including the number of tax brackets, credits and deductions, how capital gains and dividends are treated, and more. In recent years, inflation adjustments to tax bracket thresholds have also been important to prevent “bracket creep,” in which individuals owe more as their incomes are adjusted for rising prices.

When it comes to investing, the most important historical lesson is that the market has performed well in both high and low tax regimes. Most would expect the stock market to perform well during periods of rate cuts. 

However, the stock market experienced a strong bull market throughout the 1950s and 1960s as the country rebounded from World War II and other global conflicts when tax rates were near historical peaks. Despite these high marginal rates, economic growth was also generally strong during these decades. 

The U.S. corporate tax rates are now more competitive

Second, today’s statutory corporate tax rate is also low compared to historical levels. Prior to 2017, the U.S. had the highest corporate tax rate among OECD countries at 35%, as shown in the accompanying chart. The Tax Cuts and Jobs Act lowered the corporate rate to 21%, placing the U.S. in the lower half of OECD countries.

 Of course, corporations’ effective tax rate is typically far lower than the statutory rate due to a labyrinth of tax breaks and deductions. Naturally, this is a politically complex topic. On the one hand, corporations are maximizing their tax efficiency based on the existing tax code, which ultimately is good for employees, shareholders, and the overall economy.

On the other hand, this can be viewed as corporations “not paying their fair share,” especially when they are highly profitable, buying back shares and keeping cash overseas. This is one motivation for the 15% Corporate Alternative Minimum Tax (CAMT) for companies with roughly $1 billion in profits included in the 2022 Inflation Reduction Act.

 It remains to be seen whether this corporate tax rate and individual income tax provisions from the 2017 tax cuts will remain in effect beyond 2025. Regardless, the statutory corporate tax rate has been at this level or higher for the past 85 years, during which markets have performed exceptionally well due to business cycle expansions. 

Debt as a percentage of GDP is near historical all-time highs

Third, many investors are worried not only about taxes but also about government spending. Today, the federal debt stands at $33 trillion, more than ten times its 2000 levels, representing over 120% of the country’s gross domestic product. 

Even when adjusting for what the government owes itself, resulting in what is known as “net debt,” this number has risen to 96% of GDP. As the accompanying chart shows, the debt has ballooned during periods of economic crisis when the government spends to stimulate the economy, such as during the 2008 financial crisis and the recent pandemic. 

There are only two ways to improve budget deficits: reduce spending and/or increase revenues. Reducing spending, especially non-discretionary items such as Social Security and Medicare, have been nonstarters in Washington. Additionally, the government has not run a balanced budget since the Clinton and Nixon administrations, at the turn of the century and in the early 1970s.

 So, some investors worry that taxes could increase in the coming years. While how and when this could occur is still uncertain, it is clear that today’s tax rates are relatively low by historical standards. All investors need to consider current tax policies while planning for the future with the help of a trusted advisor.

The bottom line: Taxes are low by historical standards and markets have performed well across both high and low tax periods. Investors should maintain perspective and not overreact to tax policy changes when it comes to their investment plans.

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Matt Faubion, CFP®

Founder - Wealth Manager

This article is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your tax, legal, accounting, and financial professionals if you want more information. This content is developed from sources believed to be providing accurate information, and provided by Copyright (c) 2024 Faubion Wealth Management LLC, and Clearnomics, Inc. All rights reserved. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.