Investors take heed: new tax policies are coming. And, as wonderful as it would be for investors to be able to ignore political squabbles in Washington, current skirmishing over such tax policy makes that imprudent.
While most of the new or increased taxes proposed by President Joe Biden or the House will affect investors only indirectly, some threaten core tenets of quality shareholders, America’s most focused and long-term investors.
First, there’s corporate taxes and how they affect what quality shareholders look for in a company. Proponents of a corporate tax rate increase — to 26.5% from 21% under the House proposal and 28% under the Biden plan — assume this raises revenue without burdening individuals, especially those with lower incomes.
Critics counter that when corporations 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 as part of their analyses. Concerning how corporate tax increases affect consumers, consider three different types of companies:
● Regulated companies, such as railroads and utilities, are legally permitted to pass tax increases to their customers and invariably do so.
● Commodity-type companies, such as sellers of soap and toilet paper, are also usually able to pass at least some tax costs on to consumers.
● Franchise-type companies, those with competitive advantages such as brand strength favored by quality shareholders, may not have the option to pass along increases due to their premium pricing.
If higher corporate rates hurt franchise-type businesses more than commodity-type businesses or regulated ones, then quality shareholders must adjust. Such a change will certainly hurt them more than other investors, such as index funds or short-term traders, and will also make their favored businesses less attractive as investments.
For policy purposes, moreover, this subtler reality exposes complex trade-offs. Higher corporate taxes will hurt customers of regulated businesses most because, as taxes increase, so does the price they pay. Policymakers, therefore, must choose between high rates that hurt ordinary people and low rates that might conflict with their revenue goals.
Next up, capital gains taxes. The House proposal would increase the top capital gains tax rate to 25% from 20%. As a policy matter, increasing the cost of selling an investment may have the positive effect of lengthening investors’ time horizons and discouraging short-termism. But for quality shareholders, investors with a long-term view already, such a tax increase is a penalty. The cost to quality shareholders would induce them to hold stocks even when the fundamentals indicate that 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 this ignores the compelling rationales for special treatment of capital gains in the first place. For one, 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 levied on nominal increases in price. Above all, under U.S. tax law, capital gains received by shareholders from corporate profits have already been taxed once at the corporate level.
The reasoning behind the Biden proposal’s elimination of a lower capital gains tax rate reveals another issue for all shareholders: it appears to be Biden’s way of eliminating the tax advantage that private equity investors have compared to other investors. The tax code lets that sector cut their tax bills about in half by treating their labor as capital — fees are classified not as income taxed at the prevailing 37% marginal rate but as “carried interest” capped at the prevailing capital gains rate, typically 20%.
Eliminating this loophole has long been proposed as a simple, sensible way to boost fiscal revenue and rationalize the tax code, including in some Senate bills being drafted. The Biden proposal pretends to solve the issue by increasing the capital gains rate to equal the top marginal income tax rate. The House proposal shows this is unlikely to happen. 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 publisher, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America.” For updates of Cunningham’s research about quality shareholders, sign up here.
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This post was originally published on Market Watch
