Tax Policy and Your Portfolio

If certain TCJA provisions aren’t extended past 2025, individual income tax rates could rise—with the top marginal rate going back up to 39.6%, from 37.0% currently. Also, estate tax exemptions could be cut in half. However, with an estimated 86% of Americans facing tax increases if the TCJA fully expires, we believe both major parties have an interest in keeping certain taxes low.

If Democrats win both legislative chambers, they may revisit tax increases for the wealthiest taxpayers, including higher capital gains and marginal income tax rates. In contrast, if Republicans control Congress, they may seek to keep the TCJA’s higher exemptions for both the alternative minimum tax and the estate and gift tax, while also possibly keeping the estate-tax exemptions at current levels. Such measures could reduce tax liability primarily for wealthier investors.  

The TCJA’s potential expiration means corporate tax changes could be on the table. Democrats may seek to boost the corporate income tax rate from 21% to as high as 28%, which Morgan Stanley strategists have said could weigh on S&P 500 company earnings. In a split House and Senate, a more modest tax rise to 25% might put less pressure on earnings. Republicans, meanwhile, have proposed reducing the corporate income tax rate to as low as 15%, which could support higher earnings.

All that said, while the tax debate could drive equity-market volatility in the near term, we believe any direct impact on earnings would likely be manageable for companies.

Historically, higher corporate, income and capital-gains tax rates have little correlation with stronger or weaker growth or equity-market performance. Data suggests, for example, that a high capital-gains rate should not hamper the economy. Similarly, changes to individual and corporate income taxes and effective capital-gains tax policy are weakly correlated with S&P 500 Index performance.

In short, a higher tax burden does not directly translate to negative or positive stock returns. Here again, investors should remember that the business cycle is likely to be more relevant to market performance than the tax policies of one political party or the other. 

Regardless of which party wins the presidential or congressional races in November, budget growth is likely to keep federal deficits elevated. If the current budget trends persist, the government’s net borrowing costs, or “net interest outlays,” could account for 59% of the federal deficit by 2034, up from 39% currently, and the total deficit could rise to 6.9% of GDP, from 5.6% currently.  

Because both parties’ policy proposals are likely to include increased spending and/or the extension of major tax cuts, this could foster notable budget imbalances over time. That suggests that taxes are likely to rise in the future, affecting both individuals and corporations. 

With the potential for higher taxes, investors may consider tax-advantaged products, securities and accounts, some of which are designed to improve tax efficiency and maximize net gains. For example, municipal bonds may be appropriate for investors who qualify for their exemptions from federal, state and local taxes.

Furthermore, tax-advantaged accounts, such as IRAs and 401(k)s, may provide either pre-tax or post-tax benefits. Investors may also consider strategies including tax-loss harvesting and tax-efficient indexing.