Democratic congressional officials recently intimated that they intend to propose legislation to tax billionaires’ unrealized capital gains on an annualized basis. On the surface, it seems like a novel approach for the current administration to unearth more tax dollars from the ever evasive top 0.0002%. However, the concern from market professionals and economists is that it could have unintended consequences. The details are sparse to this point, so it’s not entirely clear whether and to what extent this could impact investment vehicles, such as exchange traded funds, which allow for redemptions to be efficiently delivered via an in-kind transfer as well as customized baskets for fund rebalances, which are all currently viewed as tax exempt transactions by the IRS. There’s also concern that, while the headline focus is on the top wealth holders, this could start a slippery slope of taxation on investors as a whole. Furthermore, even if the focus is on that group of people, it could cause liquidity issues with so many high-net-worth individuals raising capital by liquidating assets in the market place to pay their increased tax bill.
That said, there is no precedent for taxing unrealized gains, so it’s difficult to gauge the exact impact it may have on the markets and the economy. The best gauge we have is to examine historical instances when the realized capital gains tax rate was increased and decreased as well as when the top end personal income tax rate was increased and decreased.
Note: Includes short and long-term net positive gains. Long-term gains excluded prior to 1987 are included in realized capital gains. Data for each year include some prior year returns. (a) The maximum tax rate includes effects of exclusions (1954-1986), alternative tax rates (1954-1986; 1991-1996), the minimum tax (1970-1978), alternative minimum tax (1979-1996), income tax surcharges (1968-1970), and the 3% floor under itemized deductions (1991-1998). Capital gains taxes for 2015 to 2018 are estimated on a fiscal year basis from the Congressional Budget Office.
Midyear rate changes occurred in 1978, 1981, 1997 and 2003.
The illustration above shows the relationship between the historical capital gains tax rate versus realized capital gains as a percent of U.S. Gross Domestic Product (“GDP”). You’ll notice there are three distinct points when the capital gains tax rate was risen for prolonged periods: 1968 to 1978, 1987 to 1997, and 2013 to 2017. In each of those periods, there appears to be a high correlation between the persistently high capital gains tax rate and a low realization of gains relative to U.S. GDP. Of course, a contracting economy can artificially increase the ratio of gains to GDP. Below is a chart to demonstrate the relationship between the capital gains tax rate and corresponding GDP growth:
Source: GDP data from FactSet. Capital gains tax rate from the Treasury Department, Congressional Budget Office from 1954 through 2018.
Note: Includes short and long-term net positive gains. Long-term gains excluded prior to 1987 are included in realized capital gains. Data for each year include some prior year returns. (a) The maximum tax rate includes effects of exclusions (1954-1986), alternative tax rates (1954-1986; 1991-1996), the minimum tax (1970-1978), alternative minimum tax (1979-1996), income tax surcharges (1968-1970), and the 3% floor under itemized deductions (1991-1998). Capital gains taxes for 2015 to 2018 are estimated on a fiscal year basis from the Congressional Budget Office.
Midyear rate changes occurred in 1978, 1981, 1997 and 2003.
We can see in those same periods, U.S. GDP was actually expanding, therefore, it does not appear as though a contracting U.S. economy contributed to an artificially high realized gains to GDP ratio. Therefore, we believe we can infer that the increased capital gains rate in those periods disincentivized investors from turning over their portfolios.
The above charts are limited to long term capital gains, as short-term capital gains are classified as personal income, and therefore, are dependent upon an individual’s tax bracket. Let’s take a look at the relationship relative to the top end personal income tax rate:
Source: Treasury Department, Congressional Budget Office from 1954 through 2018.
Note: Includes short and long-term net positive gains. Long-term gains excluded prior to 1987 are included in realized capital gains. Data for each year include some prior year returns. (a) The maximum tax rate includes effects of exclusions (1954-1986), alternative tax rates (1954-1986; 1991-1996), the minimum tax (1970-1978), alternative minimum tax (1979-1996), income tax surcharges (1968-1970), and the 3% floor under itemized deductions (1991-1998). Capital gains taxes for 2015 to 2018 are estimated on a fiscal year basis from the Congressional Budget Office.
Midyear rate changes occurred in 1978, 1981, 1997 and 2003.
Once again, we find correlation between the tax rate and the realization of gains relative to the U.S. GDP. We notice as the tax rate is increased between 1990 and 1987, realized gains to GDP begins to dip from previous levels. We also see this pattern between 1999 and 2001 but not as much between 2013 and 2017. However, we believe we can infer similar assumptions as contemplated in the chart relative to the capital gains tax rate.
How does that relate to taxing unrealized gains? Democratic congressional officials will argue that this will allow the federal government to increase capital gains tax without the consequence of curbing portfolio turnover as discussed in the above charts. According to the above research, they are at least partly correct: raising tax rates tend to lead to less portfolio transactions, thus, less gains are realized, resulting in less tax revenue for the federal government. Taxing unrealized gains allows the federal government access to those gains and seemingly increase the tax rate on those gains without fear of that consequence.
However, as investor behavior has demonstrated, an introduction of new/rising tax rates seems to result in investors finding ways to avoid that tax. The concern is the unintended consequences that may have on the rest of the market, particularly smaller investors. Some of those unintended consequences could be the impact on various factors in the market.
Source: Factor Return data from FactSet 12/31/99 through 12/31/18. Capital gains tax rate from the Treasury Department, Congressional Budget Office from 1999 through 2018.
“Volatility” is based on returns from the S&P 500 Low Volatility Index, “Growth” is based on returns from the S&P 500 Growth Index, “Value” is based on returns from the S&P 500 Value Index, “Yield” is based on returns from the Dow Jones US Selected Dividend Index, “Momentum” is based on returns from the S&P 500 Momentum Index, “Size” is based on returns from the S&P 600 Index.
The above chart demonstrates the outperformance and underperformance of each market factor when the capital gains tax is lowered versus when it is raised. You’ll notice that every market factor performs better when the capital gains tax rate is lowered versus when it is raised, except for volatility and yield. We believe that increased capital gains taxes increase market volatility more than periods when capital gains taxes are lowered, therefore, it stands to reason that the volatility factor performs better when capital gains taxes are on the rise versus when they are lowered. We also believe that the yield factor seems to perform better when the capital gains tax rate rises as the gap between the tax rate of capital gains and personal income narrow, thus making income-oriented investments more attractive.
We believe that we can apply similar logic to an introduction in unrealized capital gains tax. A rise in unrealized capital gains will almost certainly be met with market volatility as investors accept the fate of paying taxes whether they hold or liquidate their positions. Furthermore, they will realize a need to raise capital to pay the tax bill. While the introduced legislation is devoid of details, if we assume that investors will only be taxed on gains from capital appreciation, dividend paying securities may benefit as investors recognize that they will be faced with a tax event in either scenario through receiving a dividend payment or building capital appreciation within the calendar year.
In any event, we believe it’s important for investors to stay balanced in the face of uncertain legislation. While the fate of this legislation is very uncertain, it’s something for investors to keep an eye on as any potential modified version of this legislation could still lead to drastic market reactions.
By: Justin Lowry, President & CIO, Global Beta Advisors, LLC
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