What Does the Biden Tax Plan Mean for Investors?
President Joe Biden has proposed sweeping tax changes that will be hotly debated in Congress. His plan is intended to increase revenue for the government to pay off public debt while making the distribution of tax collection fairer.
The Tax Foundation, a non-profit think tank based in the Capitol, has estimated that Biden’s plan would generate $3.3 trillion in revenue over the next ten years . Find out what it could mean for investors and review the most important proposed changes below.
High-Income Earners Will Pay More
High-income earners will pay more income tax if Biden’s plan passes through Congress.
Individuals earning more than $400,000 annually could be taxed up to 39.6% on any income over the threshold. This could change the way that the wealthy structure their taxes and income. Historically, wealthy individuals have used creative ways to limit tax liability, including negotiating bonuses early to avoid tax increases. Individuals could also reinvest in specific retirement packages that shield them from taxes today, opting to instead pay interest when retirement funds are accessed. Real estate has also proven to be a viable shield of taxable income. All these carry some risk, considering that future tax structures are difficult to predict.
Corporate Earnings Could Decline
Although the stock market has rallied under Biden, it could look a little less bullish if his tax plans are signed into law.
Biden has proposed that corporate taxes increase, to place some of the nation’s fiscal burden back on corporations. The current proposal is that the corporate tax rate increases from the 21% implemented by former President Donald Trump, up to 28%. Biden’s new rate would still be lower than the 35% corporate tax rate that existed under former President Barack Obama.
Corporations can afford to pay the increase but it would cut into earnings. Godman Sachs estimated that a 28% rate could cut up to 9% from corporate earnings in 2022.
Real Estate Inheritance Would be Impacted
One aspect of Biden’s tax plan is a proposal that includes tax exemptions for up to $1 million for individual heirs, and $2.5 million for couples. This would mean that anyone inheriting more than the excluded amount would be subject to a hefty tax bill. This could prevent some families from keeping a family home if they don’t have funds available to pay for the capital gains tax.
One way around this could be to place family homes into qualified personal residence trusts. This would remove a home’s value from the estate, eliminating the tax burden.
Biden’s Tax Plan is Sometimes Misrepresented
Investors are concerned about Biden’s proposal but the details have sometimes been misrepresented. The biggest impact will be on corporations and high-income earners, not the average American. Stock market returns could decrease under Biden if the corporate tax rate is changed, but this is yet to be determined.
As it stands today, all changes are only proposed and the actual details could look very different under the scrutiny and changes that Congress could implement. There’s no guarantee that Biden’s proposals will even pass through lawmakers. Members of the House and Senate will want to see that any changes are beneficial for the economy at large, without unfairly impacting those who inherit properties, or the mom and pop investors who rely on the stock market for income and retirement.
Is the U.S. Stock Market Overpriced?
The current U.S. stock market is expensive, with some observers going as far as saying that it’s overpriced.
Investors engaged in the market, or anyone considering buying stocks soon, should consider the situation. Overpriced stocks can suggest that the market will eventually enter a downturn which could devalue any investments made today. What’s the best way to gauge the health of the market?
Using the S&P 500 Index as a benchmark, let’s see if the U.S. stock market is overpriced…
Using the P/E Ratio to Determine Stock Market Health
The P/E or Price to Expense ratio is one of the most important metrics used to measure stock market health. The S&P 500 Index currently has a trailing P/E ratio (an average of the previous twelve months) of $30.23.
This means that investors are paying as much as $30, on average, for every $1 of corporate earnings. For many, it would seem a hefty price for investing in stocks, but this is a bull market.
In a bull market, investors are generally optimistic that prices will increase. That optimism alone can drive prices upwards. This is what we have seen recently with record highs across all major indexes. The S&P 500 has an implied earnings growth rate of 31.04% for the next year, suggesting that the index will expand, keeping the bull market alive.
Corporate earnings drive demand for stocks. If publicly traded companies continue to grow, then the market’s momentum should be maintained.
What’s Driving the Stock Market Today?
Besides corporate earnings, other factors are driving investor confidence.
- The Coronavirus Pandemic is ongoing, but it is being managed better than it was a year ago. Widespread shutdowns are now easing and some of the most affected states, including New York, are opening back up for business. Fewer economic restrictions from the Coronavirus should help to support corporate growth in the coming months. An increase in the speed of vaccine rollouts nationwide has also contributed to investor confidence.
- America’s economy is recovering from the Pandemic. In the first quarter of 2021, U.S. GDP (Gross Domestic Product) increased at a rate of 6.4% . This compared positively to the final quarter of 2021 where GDP increased by 4.3%. Government stimulus measures through individual payments and initiatives like the Payment Protection Program have had a positive impact.
When considering the strong GDP growth, it could be argued that the stock market isn’t overpriced at all, even though investors are paying record prices for popular growth stocks. However, much of this growth has been spurred by the federal government’s stimulus program to individuals and corporations. If the government economic intervention cease then stock evaluation could take a significant dive.
The Bottom Line: Is the U.S. Stock Market Overpriced?
There’s some subjectivity at play when answering this question. Investors are paying more for stocks today. With earnings growth expected over the next year, movement in the market could be sustained. P/E is higher than its historical average so all investors should have some precautions.
Are We in an Everything Bubble with a Risk of Declines?
Asset prices have increased significantly in recent months, with everything from stocks to the home market on the rise. Even when factoring in some intra-day stock index dives, the trend is still positive.
This has led some investors and analysts to warn of asset bubbles with the risk of significant declines once investors become more risk-averse. For the average investor, is this something to be concerned about, and are we in an everything bubble today?
Federal Reserve Warns of Potential for Significant Declines
The United States Federal Reserve has warned that as asset valuations climb, there’s an increased risk of major declines.
- The S&P 500, a major stock market benchmark, has gained 10.54% in the year so far and 44.67% when looking at data over the previous 12 months.
- The NASDAQ Composite, another market benchmark, has gained 3.89% in the year so far and 48.73% when looking at data over the previous 12 months.
- S. home prices increased across the board in the first quarter of 2021. In metro areas, median prices increased by 10% compared to the previous year.
- Even non-traditional investments like cryptocurrencies have been soaring. Bitcoin, by far the largest digital currency for investment, has gained 101.73% in the year so far.
When looking at all of these markets, it would be easy to claim that they’re all bubbles. After all, growth can’t be sustained forever.
In the Federal Reserve’s May 2021 Financial Stability Report , the central bank identified four major vulnerabilities for the markets in 2021.
- Asset valuations are high, but they are vulnerable because they could rapidly decline if investor risk appetite decreases. This is true of the market in any given year. When investor confidence fails, the markets decline – effectively ‘bursting’ the bubble.
- If borrowing increases, the risk of an asset crash will likewise increase. Business debt was flat in the second half of last year and household debt is moderate in relation to income. The government has taken steps to reduce household debt delinquency with mortgage forbearance and fiscal programs.
- Banks are well-capitalized but the Federal Reserve warns that the existing data isn’t extensive because it lacks hedge fund and other leverage fund data.
- Money market funds, bonds, and bank loan mutual funds are at risk, even though overall domestic bank risk remains low. The Federal Reserve highlighted the fact that there was market turmoil at the onset of the Coronavirus Pandemic in 2020, suggesting that any major economic event could put funds and bonds at risk.
Why are Asset Prices Rising?
The Federal Reserve has pointed to several factors as contributing to the rise in asset prices.
- Vaccine-related news has increased confidence in the markets. With mass vaccinations, the threat of economic disruption akin to 2020 is minimized.
- Additional fiscal stimulus, including the $1.9 trillion American Rescue Plan Act of 2021, has had a positive impact on the markets. The Act provides financial support for businesses and households through relief programs and direct stimulus payments.
- The Federal Reserve has injected money into the market to support it, buying up to $80 billion in treasuries and $40 billion in mortgage-backed securities each month.
- GDP is increasing rapidly. The growth rate in the first quarter was 6.4% .
The Federal Reserve could reverse its quantitative easing policy (injecting money into the markets by purchasing assets) as early as next year if economic growth continues. Target interest rates could also increase beyond the 0% that the Federal Reserve has currently set.
The key will be to balance the change in policy in a way that makes sense to the market and the wider economy. We are in an everything bubble in terms of the price of assets, but these prices are well supported for as long as investors have a risk appetite. With the economy getting stronger, growth could continue for months or even beyond 2021.
Is it Time to Expect Lower Returns on Asset Investments?
Asset investment confidence has been high in recent months, driven by a booming economic recovery in the United States and a sense that the Coronavirus Pandemic is being brought under control.
Investors have been drawn to investments like stocks, bonds, and real estate, seeing some security, as well as the potential for strong gains.
One of the biggest challenges for financial advisors and anyone in the industry is keeping the expectations of investors in check. Investors, particularly those who are inexperienced, often demand larger returns than what the market can actually provide. Even some experienced investors may have become accustomed to unreasonably high returns, due to the relative strength of the stock market in recent years.
What Does Market Research Say About Investor Confidence?
Asset growth in the last year suggests that investors have a risk appetite, yet surveys show that investors still have reduced expectations regarding their short-term targets.
The data doesn’t always relate directly to expected returns, but it can still offer context.
- According to a 2020 Gallup Survey , investor optimism hit a four-year low in the second quarter of 2020. Even as it recovered towards the end of last year, it remained less than half, on a points basis, of what it was in the first quarter of 2020.
- Investors that follow industry news likely expect smaller returns on their investments in the coming years. PWL Capital, a major investment advisory firm, recently released data suggesting that the nominal rate of return on investments moving forward will be 6.0% when factoring in expected inflation .
6.0% is a return that’s far smaller than the 10%, 20%, or even 30% that some inexperienced investors expect to receive when first entering the asset market. However, it’s also in line with historical averages.
Looking back over the previous 121 years, global equities have produced a real annualized average return of 5.2%.
Should Investors Expect Lower Returns in the Coming Years?
Even with some recent pullbacks, the stock market is stronger than it has been in history. The bond market is stable although returns are relatively weak. Real estate is strong, with the median selling price of a home in the U.S. up by 10% in the first quarter, compared to 2020.
To say that investors should expect smaller returns is a poor way to position the current investment economy. It all depends on the individual investor. Relative to the previous year, some investors could expect stronger returns, especially when selling real estate assets.
Bond returns are expected to be low (although reliable) because of the low interest rate environment. Stock returns are difficult to predict although the market is relatively positive today. America is in the middle of an economic recovery. GDP expanded by 6.4% in the most recent quarter.
As long as the recovery is ongoing, asset returns are likely to remain moderate to strong, just as they are today. The 6.0% nominal rate of return suggested by PWL Capital is an excellent benchmark point because it is both realistic and consistent with historical expectations.
Growth periods (like today) are ideal for generating strong returns. As long as investors are aware that the conditions won’t last forever.
Any investor expecting returns above 10% in a well-diversified portfolio should reassess their targets and recognize that rapid growth and high returns can’t be sustained. Experienced investors happy to take sustainable but slightly lower returns will be satisfied with the asset market in the months ahead.
How Have Central Banks and Governments Responded to the Global Pandemic?
The COVID-19 pandemic has created one of the most unprecedented global financial events in modern history. The human and social costs of the virus have been vast. The financial costs threaten economies worldwide.
Central banks have played a central role in mitigating the damage of the pandemic, with fiscal policy helping to offset a drop in consumer spending and the resulting decrease in gross domestic product.
Central banks, and their respective governments, have used several financial tools to help stabilize economic slowdown.
Stimulus in Major Economies
The European Union has created one of the largest stimulus packages in history to help offset the impact of the global pandemic. A $2.21 trillion (USD) package has been approved by all member states except Poland and Hungary. The package includes a long-term budget for Coronavirus recovery that would run from 2021 to 2027. It includes more than $815 billion (USD) that will go directly to recovery programs and reform in member nations.
Central bank rates, which influence the cost of borrowing at an institutional level (with a trickle-down effect on corporate and personal borrowing) have also been lowered during the pandemic .
- In the United States, the rate is held at 0.250%.
- In the United Kingdom, the rate is held at 0.100%
- In Japan, there is a negative rate of -0.100%, intended to stimulate borrowing to prop up the economy.
All of the world’s major banks have implemented historic-low interest rates in 2020, excluding China and Russia. China’s central bank rate is currently maintaining at 3.850%, while Russia’s is at 4.250%. China was the first nation to be impacted and the first to recover from the pandemic, with its vast manufacturing economy helping to drive growth towards the end of the year.
The United States has also offered direct stimulus in the form of aid to businesses, as well as payments of $1,200 to individuals earlier in the year. The CARES Act was passed into law on March 27 and contained more than $2 trillion (USD) of economic relief .
The United States Congress is currently negotiating the terms of a new stimulus package which could include direct payments and unemployment subsidies for people who have been impacted by the pandemic. It is also likely to include paycheck protection loans for businesses that are struggling in 2020.
Keeping small businesses from failing during the pandemic is a key strategy for recovery in all developed nations.
Gaining Insight from Government Bonds
Government Bonds are an important measure of the current economic situation. Long-term interest rates on government bonds are implied by the prices of bonds as they are traded. Repayment of bonds is guaranteed by central governments, giving them strength, even in periods of economic uncertainty.
The lowering of global bond interest rates throughout 2020 is somewhat related to central bank rates, but they do deviate. Lower long-term rates can attract investment, helping to stimulate economic growth.
The following charts show government bond interest rates for members of the Group of Seven (G7), a highly influential group of nations with some of the largest regulated economies in the world . Australia is included as a non-member but key global economy.
Global Economy is Still in Crisis
The global pandemic is far from contained, and major institutions predict that the global economy will decline, especially in emerging markets. Major economies have managed conditions well so far, but it’s yet to be seen how far interest rates, issuing of government bonds, and direct stimulus will go towards supporting a recovery.
- Global Rates Central Banks – Summary of Current Interest Rates – https://www.global-rates.com/en/interest-rates/central-banks/central-banks.aspx
- U.S. Department of the Treasury – The CARES Act Works for All Americans – https://home.treasury.gov/policy-issues/cares
- OECD Data – Long-term Interest Rates – https://data.oecd.org/interest/long-term-interest-rates.htm