Talk of a proposed tax on unrealized capital gains put forth by Democrats has sparked a torrent of bearish prognostications if it were to happen.
Some high-profile investors say the market impact won't be pretty if the super-wealthy's "paper gains" on assets they haven't sold are taxed. Under current law, any asset appreciation isn't taxed until it is sold. Some call this proposed change a Billionaire's Tax.
Billionaire Mark Cuban says it will "kill the stock market." Hedge fund titan John Paulson warns that Democratic presidential nominee Kamala Harris' proposed tax increases on corporate profits and capital gains and the added tax on the uber-rich's paper gains will cause a "crash in the markets" if they become law. Sam Stovall, chief investment strategist at CFRA Research, says if the Billionaire's Tax is enacted "it will throw the market into a mega-meltdown bear market."
Speculating About Unrealized Capital Gains Tax
These predictions are pure speculation. Nobody knows how such a tax would impact the stock market.
It's also important to note that the Harris campaign has not yet put forth a formal proposal for the Billionaire's Tax. It's thought to apply a 25% annual minimum tax on unrealized capital gains on centimillionaires with assets of $100 million or more. The Democratic nominee has merely said she backs tax-related proposals put forth by the Biden administration.
What's more, Wall Street places very low odds on the Billionaire Tax passing. It expects a divided Congress after the November elections. And Republicans don't back the Billionaire's Tax.
Still, how could such a tax – whether it's targeting the roughly 10,000 centimillionaires in the U.S. or if it eventually extends to more Americans — impact markets?
Specifics are scant. It's believed the tax would work like this: If you invested $100,000 in a stock on Jan. 1 and it was worth $125,000 on Dec. 31, you'd be subject to a tax on the $25,000 gain. That's even if you never sold the stock.
"Obviously, nothing like this has ever been done in the U.S., and it opens the door to the unknown and so much uncertainty," said Tim Steffen, director of advanced planning at money management firm Baird.
How An Unrealized Capital Gains Tax Could Hit Your Bottom Line
The first risk is investors might be forced to sell some assets to pay taxes. At the end of the year or heading into tax season, the nation's stock investors with annual unrealized gains will need to come up with the cash to pay their tax bill virtually at the same time. "You wouldn't have a way to avoid it," said Steffen.
Currently investors can avoid capital gains by simply not selling their winners. And that means investors who don't have the money in a savings account to pay Uncle Sam will have to sell assets to raise money to meet their tax obligation.
This need to sell, obviously, could come at an inopportune time or make little investment sense.
"Everybody's going to do it (sell)," explains Eric Veiel, head of global investments and chief investment officer at T. Rowe Price. "You'll just be forcing more selling at known times, which is not a good thing. You are introducing liquidity risk into the market, which would then increase volatility."
This forced selling hurts investors in three ways. First, having to sell assets to pay taxes reduces the amount of money in your investment account. That reduces the benefits of compounding.
"Whether you take money out of your portfolio to spend it on a nice vacation or give it to the government in taxes, you have less in your account to invest and grow," said Steffen.
Pressure The Stock Market With An Unrealized Capital Gains Tax
Second, all that selling around the same time could place downward pressure on the stock market, adds Steffen.
There's also a risk big investors yank all of their money out of the market to dodge market uncertainty or a big tax bill. For example, Paulson, the billionaire hedge fund manager, says he'll pull his money out of U.S. financial markets if Harris is elected and pushes through her tax policies. Paulson said he will go to cash and gold.
"If the big money (investors) pulls their money out, yeah, I would think it's going to have a negative impact," said Steffen.
Unrealized Capital Gains Tax: Trigger A Crisis?
Finally, leverage (or the inability to pay back borrowed money) or lack of liquidity often strains markets, Veiel notes. Markets tend to suffer when market participants are forced to sell and other investors know they must sell.
On the bright side, Denmark is one country that taxes some unrealized gains. And Danish stock market returns have not suffered by the tax based on some measures. IShares MSCI Denmark ETF, for example, is outperforming Vanguard's S&P 500 ETF in the past one- and five-year periods. The U.S. stock benchmark has topped Denmark's returns, though, in the past three- and 10-year periods.
Another risk? Tax on paper gains could shrink stocks for sale in the market. The more investment choices investors have, the better. But there's a risk that a tax on unrealized capital gains could either dissuade private companies from going public or starve them of the capital they need to grow.
And if more innovative companies with a long growth runway stay private, that shrinks the number of stocks to invest in. It also makes it that much harder for Main Street investors to participate in their growth.
"It could deter capital formation in the U.S.," said Veiel. "When that happens, people's 401(k)s, IRAs and 529 plans don't get access to the best companies."
Distort Investors' Moves?
A tax on unrealized gains could distort investment behavior. That's especially true when it comes to small caps, startups and early-stage companies, according to Frank Holmes, CEO and chief investment officer at U.S. Global Investors.
"These businesses are often the engines of growth and innovation within the economy, but they rely on investments from those willing to take risks for the promise of future returns," Holmes wrote in a blog post. "Knowing that their unrealized gains will be taxed, investors would be less inclined to invest in growth-oriented businesses."
Some upstart companies might also opt to shift their headquarters and operations to other countries with more investor-friendly tax rules. "There's no divine right that every great startup has to be in the United States," said Veiel.
An unintended consequence, Veiel adds, is that the tax on unrealized gains "creates an incentive for people to move away from the best market in the world (the U.S.) from a liquidity and regulatory perspective into less-regulated, less-liquid markets."
Investors and capital would flee the U.S. While it's not likely that a tax on unrealized gains will occur, if it does don't be surprised if there's an exodus of people and capital from the U.S., says Jay Hatfield, CEO of Infrastructure Capital Advisors.
"It would cause a wave of people and corporations leaving the United States to avoid the tax," said Hatfield. "There'd be no capital. We'd have lower economic growth."
Capital Gains Taxes On The Rise?
The bigger risk facing the stock market this year, according to Hatfield, is if the Democrats sweep all chambers of government and impose an increase in the capital gains tax from 20% to 28%.
"The expected increase after the sweep would very likely result in a wave of tax-gain harvesting this year as investors will assume the cutoff date will be Dec. 31, 2024," said Hatfield. "The selling will likely be concentrated in the tech sector and result in extreme pressure on the markets heading into year-end."
Details on how such a tax on unrealized gains would be implemented are scant. It's still unclear as to whether this tax on paper gains would pertain to investments held in tax-deferred retirement accounts such as 401(k)s or IRAs.
But if retirement accounts are shielded from taxes on unrealized gains, that would mean a huge part of the market and Main Street America's nest egg would be unaffected, says Lamar Villere, partner, and portfolio manager at money management firm Villere & Co.
A Bright Side To Unrealized Capital Gains Tax
And even if a tax on paper gains ever came to fruition, there's a few good things that may arise, Villere says. Many clients and investors, he says, have huge, concentrated positions in individual stocks that they refuse to sell because they don't want to pay taxes on the gains. But if a tax on unrealized gains became law, it would incentivize them to sell and better diversify their portfolios. "Too many investors now let their tax decision drive their (asset allocation) decisions," Villere said.
Villere also notes that investors would need to return to stocks, which still offer better growth potential.
Investors "can't just decide, 'I don't like this tax and am going to sell all my stocks,'" said Villere. "You gotta buy something."
