History shows the stock market doesn't like higher taxes

Published Mon, Apr 26 202111:00 AM EDTUpdated Mon, Apr 26 202112:57 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

When Washington raises both corporate and individual tax rates, stocks typically underperform in the first year and sell off in the second year, according to BTIG. President Joe Biden this week is expected to propose raising individual taxes for the highest earners to 39.6% and capital gains taxes for those earning over $1 million to as high as 43.4%. That comes on top of his plan to raise corporate taxes to 28% from 21%, proposed to pay for infrastructure spending. "Everyone says raising the capital gains tax is not a big deal for markets, and it's ludicrous to think that," said Julian Emanuel, head of equity and derivatives strategy at BTIG. Emanuel studied the impact on stocks when both the individual and corporate tax rates were hiked. He notes there were some stinging examples in years when capital gains rose. The S & P 500 has been positive 62% in the first year when taxes rose, but gained on average 2.4%, well below its long-term annual average of 7.7%. The second year was more painful. The S & P 500 on average declined 0.9% and was negative 54% of the time. In the most recent example, the S & P gained 7.1% in 1993, the year the top individual tax rate was raised to 39.6% and the corporate tax rate was raised to 35%, the levels they were at when the Republican-led tax cuts slashed them in 2017. In 1994, the S & P 500 then lost 1.5%. But after the tax increases of 1968, the gains and losses were larger. In the first year, when the top individual rate was raised to 75.3% and corporate taxes went to 52.8%, the S & P rallied that year by 7.7% but sold off by 11.4% in 1969. "Taxes matter. Tax hikes matter. Capital gains tax hikes matter," wrote Emanuel in a note. "It is unlikely that all tax rates are going to rise in 2021. We hope. Investors hope." Emanuel found some powerful examples of market behavior, like when the capital gains tax was raised in 1986. It was followed by 1987, "a year with slight gains (2.3%) sandwiched between the greatest crash in the history of the markets," he noted. Emanuel said on Monday that he has changed his view on Big Tech growth stocks . He became positive on those stocks in mid-February. "We were clear that it was a tactical trade," he said in a telephone interview. "Now that's over ... If there's going to be selling ahead of a capital gains tax hike, those are the names that are going to get sold." Emanuel also warns that the higher capital gains tax coincided with a long negative period for stocks. He cited the lost decade for stocks, which started with that 5.3 percentage point increase in individual taxes and a near 5 percentage point increase in corporate taxes in 1968. "We would point out that the cap gains tax rate began to rise in 1968, and peaked at 39.875% in 1976 and stayed there until 1978," he noted. "... the Dow Jones Industrial Average traded as high as 985.21 in 1968, and in 1978 as high as ... 907.74." Even so, Emanuel expects this bull market to keep on running. "We view the current Bull market as having further to run despite the near-term potential for a pause, consistent with the idea that the average bull market of the past Century has lasted 51 months and gained 154% vs. the current Bull at 13 months and 90%," he wrote.

A general view of the U.S. Capitol in Washington, U.S., April 22, 2021.

Erin Scott | Reuters

When Washington raises both corporate and individual tax rates, stocks typically underperform in the first year and sell off in the second year, according to BTIG.

President Joe Biden this week is expected to propose raising individual taxes for the highest earners to 39.6% and capital gains taxes for those earning over $1 million to as high as 43.4%. That comes on top of his plan to raise corporate taxes to 28% from 21%, proposed to pay for infrastructure spending.

"Everyone says raising the capital gains tax is not a big deal for markets, and it's ludicrous to think that," said Julian Emanuel, head of equity and derivatives strategy at BTIG.

Emanuel studied the impact on stocks when both the individual and corporate tax rates were hiked. He notes there were some stinging examples in years when capital gains rose.