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Capital Gains Tax Hike an Opening Bid - Fluid Process and Potential Compromise

The proposed hike in the capital gains rate to the envisioned ordinary income rate of 39.6% on incomes above $1 million as part of President Biden’s American Families Plan is likely to see adjustment on the rate or the income threshold, in our view.

A higher capital gains rate is a staple of Biden’s “economic fairness” agenda and has been well communicated over the course of his candidacy/Presidency, but we expect the market reaction seen Thursday to raise hesitancy among moderate Democrats and serve as a potential moderating force. Further, electoral consequences in the 2022 midterms could serve as a limiting factor, depending on how the politics on this issue play out.

In an aggressive scenario of a 39.6% rate being effective in 2022, we would expect to see continued market volatility as the Biden infrastructure/tax agenda makes its way through Congress.

Reported capital gains hike likely an opening bid. Possible avenues for compromise include the below, in our view:

  • A lower rate from the 39.6%, possibly tying it to the current 37% top marginal rate. In this scenario, the highest individual rate is left the same, but capital gains is brought up to ordinary income levels.

  • A higher income level from the reported threshold of incomes above $1 million. There is recent precedent for this, as Treasury has significantly revised a potential minimum corporate tax rate to only affect profits above $2 billion from the originally-proposed $100 million. For reference, Elizabeth Warren’s proposed “wealth tax” targeted assets above $50m.

  • A longer phase in period, possibly until 2023 to avoid a hit to personal finances ahead of the 2022 midterms.

Dividend taxation needs further clarification. We expect less of a chance of dividends being matched at the higher capital gains rate.

Market reaction may influence support among more moderate Democrats. Support for a capital gains rate hike with some moderating adjustments to the current proposal would likely be the preferred policy path forward for moderate lawmakers.

Path forward. The infrastructure strategy remains undecided, raising the uncertainty on the path forward for tax changes.

Timing will be key to market impact. A retroactive effective date of January 1, 2021 could limit the degree of implementation date volatility. Forward implementation would likely drive periods of volatility.

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