Over the weekend Congress continued to work on the budget proposal and its accompanying tax increases. It looks like reconciliation will be used to pass them. On Saturday, the House Ways and Means Committee released 650 pages of legislative text for renewable energy, social safety nets, infrastructure bonding, and health care proposals. Yesterday, we saw the unofficial, initial outline of the House plan for tax increases, which contained roughly $2 trillion in new/additional taxes.
The proposals being put forward are important in understanding the baseline of what can and cannot pass into law. The list below is just preliminary and subject to change. We expect the Senate bill to be different than the House bill, and we don’t expect $2 trillion of tax increases to pass into law.
We often refer to spending as “candy” and tax increases as “spinach.” It probably surprises very few people that about 90 percent of the client questions we receive are about the spinach. Below is just the spinach of tax proposals.
Corporate tax increases are roughly $900bn over 10 years and are consistent with our view of a $10 hit to S&P 500 earnings, or 5 percent next year in 2022. However, the allocation of these changes has shifted in the House plan, with more focus on the domestic tax rate than on multinational income. Individual tax increases come out to roughly $1 trillion and are very aggressive on the taxation of small business income for those with over $400k of income.
1. Corporate Tax Rate: The House is proposing to raise the corporate tax rate from 21 to 26.5 percent, slightly higher than the 25 percent target of where the political consensus lies. Raising the corporate tax rate by this amount lowers earnings by $55bn in 2022 which is a headwind for your portfolio. Our sense is that the corporate tax rate was set higher in order to offset the lower proposed tax increase on US multinational income (see below). The net effect is more tax increases from the corporate tax rate of $55bn next year and $45bn on multinational income. This is a shift from the Biden plan, which imposed more multinational tax increases than what was raised by the higher corporate tax rate. However, we expect the Senate plan to have a 25 percent corporate tax rate and higher taxes on multinationals, so that will need to be worked out.
2. Taxes On Multinational Income Are Less Than The Corporate Tax Rate Increase: Because the OECD global tax deal has not been finalized, some policymakers are concerned about raising taxes on US multinationals beyond existing levels over fear of making US companies less competitive. Nearly every OECD country does not tax foreign income of its domestic companies. The US proposal takes an existing tax on multinational income and raises it even further. The Ways and Means Committee chairman is proposing to raise taxes on multinationals, but keep the proposals somewhat in line with the OECD negotiations. The proposal raises the GILTI tax rate from 10.5 to 16.5 percent, moves to a country-by-country basis for calculating the tax (big tax increase), cuts the allowable return on foreign tangible property (Biden proposed to eliminate this) and allows for taxes paid to be carried forward. Our expectation is that the Senate proposal will be even harsher than this proposal. The House bill also lowers the deduction for foreign derived income and increases the BEAT tax rate to prevent income shifting.
3. Capital Gains Tax Rate: The proposal says that the tax rate on capital gains increases from 20 to 25 percent for those making over $400k. With the current 3.8 percent net investment income tax, the capital gains tax rate will be 28.8 percent. There is no effective date mentioned. One major caveat is that the document says nothing about raising the dividend tax rate. Our sense is that this was just an omission as the capital gains and dividend tax rates should move together. But if not, and just the capital gains tax is raised, we would expect more companies to pay out dividends than do share repurchases.
4. Estate Tax Changes Are More Traditional Than The Biden Plan: President Biden proposed to end step up in basis and tax unrealized capital gains at death. Neither are in the House plan. Instead, the plan drops the lifetime exemption to $6mm effective January 1, 2022. This is four years ahead of schedule when the Trump tax cuts expire in 2026. Additionally, the proposal changes the tax rules for NEW grantor trusts to treat them more like income tax rules, treats their sale like normal asset sales, and changes valuation rules for passive assets with partial ownership. The valuation changes do not apply to businesses or farms.
5. Changes The Holding Period For Carried Interest: The increase in the capital gains tax rate lowers the spread between ordinary income and capital gains, thereby closing some of the carried interest spread. The legislation further proposes that the holding period to qualify for carried interest increase from its current three-year period to a five-year period.
6. Individual Income Tax Rate Raised To 39.6 Percent: As expected, the House plan raises the income tax rate from 37 to 39.6 percent, but this tax rate also applies to more income of the taxpayer than the current tax rate. Currently, the 37 percent tax rate applies to income at $523k for individuals and $628k for married couples. Under the House plan, the tax rate will kick in at $400k and $450k respectively.
7. A New 3% Surtax On Income Over $5mm: The House proposal adds a new income tax rate for those making over $5mm of income.
8. A New 3.8% Surtax On Small Business Income: Similar to the Biden plan, the House proposal includes a new 3.8 percent tax on small businesses with more than $400k of income who pay the individual income tax.
9. Cuts The Small Business Deduction: Currently, business owners who pay the individual income tax, including REITs and publicly traded partnerships, receive a 20 percent deduction for their qualified business income. This deduction is ended for business owners with more than $500k in a joint return and $400k for a single taxpayer.
Context: A small business owner with $500k of income will see their income tax rate increase, the amount of income subject to that tax rate increase, have a new 3.8 percent surtax, and lose a 20 percent deduction. This business owner could be looking at a 46- 48 percent income tax rate before considering payroll taxes and state/local taxes.
10. Tobacco Tax Increase: The House proposal raises the tax rate on tobacco products and expands the tax to vaping products.
11. IRA Reforms: The legislation disallows new contributions to Individual Retirement Accounts if a balance exceeds $10mm. The legislation also requires distributions when account balances reach a certain level.
12. Income Deduction Limitations For Highly Compensated Executives: The legislation limits deductions for employees with compensation over $1mm of income and applies to the top five paid employees in 2022.
13. IRS Enforcement: Allows for $80bn of IRS audits of high-income taxpayers. The Congressional Budget Office says this could yield $200bn of revenue over 10 years.
14. Advanced Refunding of Municipal Bonds: The legislation reinstates the tax exemption on interest from state and local government refunding bonds.
15. Build American Bonds 2.0: The legislation proposes to reinstate a version of Build America Bonds, which allows qualified infrastructure bonds to receive an applicable percentage of interest to finance infrastructure projects.
Pharma Changes:
16. Direct Price Negotiation: The legislation allows for the US government to negotiate the price of drugs for Medicare for 25 drugs in 2025 and 50 drugs thereafter. The amount charged cannot exceed 120% of the volume-weighted average of the price in six countries selling those drugs. If enacted, this is a major change in the drug reimbursement system and a very large haircut to pharma.
17. Medicare Part B And Medicare Part D Inflation Rebates: Pharma manufacturers would be required to provide rebates should they raise prices for drugs above the rate of inflation in the Medicare prescription drug programs.
Source: Strategas
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by FactSet.
Sincerely,
Fortem Financial
(760) 206-8500
team@fortemfin.com
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