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The corporate tax angle no one is talking about

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·3 min read
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Tuesday, April 27, 2021

Stocks are never judged in a vacuum 

Changes in the U.S. tax code are a top of mind consideration for investors. 

Last week's headlines were primarily focused on potential changes in the capital gains tax; an increase in the corporate tax rate has also been proposed. Though as Yahoo Finance's Rick Newman notes, any eventual changes in tax rates are likely to be smaller than initial indications. 

These opening bids from the White House have, however, set off plenty of reaction among Wall Street strategists and analysts trying to answer a common question from their clients: What does this mean for markets? 

Sam Ro covered some of this work in The Morning Brief on Monday. According to Brian Belski at BMO, history is clear: stocks have gone up in years after an increase in the corporate tax rate. An increase in the capital gains take has also been followed by higher stock prices on average, according to LPL.  

Whether stocks go up after any tax change, however, isn't the main concern when it comes to how tax changes impact investment decisions. The performance of the stock market is an absolute outcome: either stocks go up or down. But for most investors, the relative performance of an asset is what matters most. 

Unless you are one of the few people running a long/short equity portfolio, investment decisions are ultimately about the relative merits of putting your money in one thing versus another: Stocks or bonds? Bonds or real estate? Real estate or cash? Cash or crypto? And so on. 

Over time, of course, stocks tend to go up

And so for many investors looking to build wealth for the long term, stocks are an attractive option. And recent history suggests that higher tax burdens don't change this asset's relative merit. 

"In 2013, although the wealthiest households sold 1% of their assets prior to the [last capital gains rate hike], they bought 4% of starting equity assets in the quarter after the change and therefore only temporarily reduced their equity exposures in order to realize gains at the lower rate," Goldman Sachs strategists wrote in a note to clients published last week. "Total household equity allocations demonstrated a similar pattern around the two preceding capital gains tax hikes." 

So while some wealthy investors realized gains ahead of the last increase in the capital gains tax, more than all of those sales were replaced by new flows into the stock market. In other words, higher taxes created a short-term incentive for some investors to sell stocks, but this same higher rate was not a long-term deterrent for those investors when it came to buying stocks. 

And so on a relative basis, stocks were still deemed the place to be even with the knowledge that future tax burdens would be higher upon sale of those assets. And Goldman expects a similar story to play out if the capital gains tax is increased this year.

"The eventual increase in household equity allocations will likely be funded, in part, by a continued rotation away from cash," Goldman adds. "U.S. households represent the single largest owner of the U.S. equity market, at 35%, and currently have cash allocations close to the 30-year average despite cash yields being substantially below average... We estimate that additional household selling of money market funds could exceed $200 billion and that a meaningful amount of that cash will represent equity demand."

Whether the tax rate faced by corporations and citizens in the year ahead is higher, lower, or the same, the question facing investors will not change: Which asset class offers the most attractive risk-adjusted returns? 

How you answer that question helps everything else fall into place.

By Myles Udland, reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland

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