Watchful investors: new tax policies are coming. And, wonderful as it may be for investors to be able to ignore political wrangling in Washington, the current skirmishes over such fiscal policy make it unwise.
While most of the new or increased taxes proposed by President Joe Biden or the House will only affect investors indirectly, some threaten the fundamentals of quality shareholders, America’s most focused and long-term investors.
First, there are corporate taxes and their impact on the quality sought by shareholders of a company. Supporters of raising the corporate tax rate – to 26.5% from 21% under the House proposal and 28% under the Biden plan – assume it increases incomes without weighing it down. individuals, especially those with low incomes.
Critics counter that when companies face increased costs, including taxes, they pass them on to customers through higher prices or to workers in the form of lower wages.
Each of these arguments is plausible in theory, but both ignore the nuances of corporate America that quality shareholders consider in their analyzes. Regarding how corporate tax increases affect consumers, consider three different types of businesses:
● Regulated businesses, such as railways and utilities, are legally permitted to pass tax increases on to their customers and invariably do so.
● Commodity companies, such as soap and toilet paper vendors, are also generally able to pass at least some of the tax costs on to consumers.
● Franchise-type businesses, those with competitive advantages such as brand strength fostered by quality shareholders, may not be able to pass on increases due to their high prices.
If higher corporate rates hurt franchise-type businesses more than commodity-type or regulated businesses, then quality shareholders need to adapt. Such a change will certainly hurt them more than other investors, such as index funds or short-term traders, and also make their favorite companies less attractive as investments.
Moreover, for political purposes, this more subtle reality leaves room for complex compromises. Raising corporate taxes will hurt the customers of regulated businesses the most, because as taxes rise, so does the price they pay. Policymakers therefore have to choose between high rates that hurt ordinary people and low rates that could conflict with their income goals.
Then there are capital gains taxes. The House’s proposal would increase the capital gains tax rate from 20% to 25%. In terms of policy, increasing the cost of selling an investment can have the positive effect of extending the time horizons of investors and discouraging the short term. But for quality shareholders, investors who already have a long-term vision, such a tax increase is a penalty. The cost to quality shareholders would make them hold stocks even when fundamentals indicate it’s time to sell.
The Biden proposal would go further, treating capital gains as ordinary income rather than being taxed at a lower rate. But that ignores the compelling reasons for special treatment of capital gains in the first place. On the one hand, capital gains are fully taxed while capital losses are not fully deductible. And capital gains are not adjusted for inflation to reflect their real value, but taken from nominal price increases. Importantly, under US tax law, capital gains received by shareholders on corporate profits have already been taxed once at the corporate level.
The reasoning behind the elimination of the Biden proposal for a lower capital gains tax rate reveals another problem for all shareholders: it appears to be Biden’s way of eliminating the tax advantage enjoyed by private equity investors over other investors. The tax code allows this industry to cut its tax bill in half by treating its labor as capital – fees are not classified as income taxed at the current 37% marginal rate, but as capped “deferred interest” at the prevailing capital gains rate, generally 20%. %.
Closing this loophole has long been proposed as a simple and sensible way to increase tax revenue and streamline the tax code, including in some Senate bills currently being drafted. The Biden proposal claims to solve the problem by raising the rate of capital gains to equal the top marginal tax rate. The House’s proposal shows that this is unlikely. Policymakers should take this issue head on. Quality shareholders could help by adding their voice to the debate.
Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group and editor, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America”. For updates on Cunningham’s research on quality shareholders, sign up here.
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