Why You Shouldn’t Overrate the 2016 Election’s Tax Policy Debate

Will the next president delete the dreaded form? Image from Internal Revenue Service.

This article centers on tax policy, which can evoke emotions from both sides of the political aisle. Please recognize our sole interest here is in assessing how changes in tax policy have historically affected stocks in order to frame expectations for what may happen if taxes are changed after 2016's election.

Maybe you have already heard whispers alluding to this, but in a short 49 days Americans will head to the polls and select the next president. While this election's atypical characteristics have stolen headlines all year, on one point, this is election season as usual: People are politicking, and when they politic, they usually make a fuss about taxes. Politicians seem perpetually unable to find the goldilocks level of taxation that is "just right"-taxes are forever too high or too low; "fair" or "unfair" for whatever reason; their plan will boost growth while their opponent's will crush it. Unsurprisingly, with all this talk, investors have a tendency to get caught up in rhetoric about tax plans-a way for political bias to infect your investment decision making. Allow us to inoculate you from this risk: There is no evidence tax changes carry the big market impact many presume-for good or ill. Vote based on tax policy if you like, but investing based on it is likely an error.

As usual, all four 2016 presidential candidates have tax plans.^[i] As noted above, some want higher rates and some lower; some want more "fairness," although there are literally three different definitions of what that means this year. Of course, presidents can't unilaterally raise, lower, abolish, restructure, rewrite or reform taxation-something President Obama encountered after campaigning to eliminate the "Bush Tax Cuts" in 2008. Despite his Democratic Party having control of Congress from 2009 - 2010, Obama wound up extending those rates through his first term. When changes were made in 2013, they were vastly watered down from campaign rhetoric. On the Republican side, George H. W. Bush famously instructed us to read his lips-"No new taxes."^[ii] Yet taxes rose shortly thereafter. The Constitution says Congress gets the power to tax and spend-the president cannot act on his or her plans unilaterally, and the result can be very different from campaign-speak.

Most of the time, investors seem to think lower taxes are uber-bullish and fear higher taxes spell trouble for stocks. In theory, this seems logical. Lower taxes mean more money in consumers', businesses' and investors' pockets to invest and spend as they see fit. Lower capital gains taxes may even make investing more attractive! Lower corporate taxes mean bigger profits for businesses. Higher taxes? Reverse all those.

But here is the thing about theory: You have to square it up against history. History is your laboratory for testing the probability your theory is correct. If your theory hasn't been repeatedly true before, buying it now may just be falling prey to bias.

For some of us, lower taxes may be joyous indeed. But does that translate to equity returns? In short, the answer is no. Exhibits 1 - 3 show the direction of a tax rate change (cut or hike) paired with whether US stocks rose or fell in the six and 12 months after the date the change was effected. As you'll see, hikes do not automatically spell trouble for stocks. Take Exhibit 1, for example. Stocks have risen the six and 12 months following a personal income tax hike 12 times and fallen in only two. So are hikes bullish? Conversely, stocks were much more mixed in the six and 12 months after a tax cut!

Exhibit 1: US Stocks, Six and 12 Months from Personal Income Tax Rate Change

Source: Global Financial Data, Inc., as of 9/16/2016. 12/31/1926 - 12/31/2015. Tax rate change is to the highest bracket.

Exhibit 2: US Stocks, Six and 12 Months from Corporate Tax Rate Change

Source: Global Financial Data, Inc., as of 9/16/2016. 12/31/1926 - 12/31/2015. Tax rate change is to the highest bracket.

Exhibit 3: US Stocks, Six and 12 Months from Capital Gains Tax Rate Change

Source: Global Financial Data, Inc., as of 9/16/2016. 12/31/1950 - 12/31/2015. Tax rate change is to the highest bracket.

That may seem counterintuitive, but it really isn't. For one, stocks move most on surprises and, as discussed above, tax plans take a long time to enact and play out very publicly. Surprise power is reduced greatly. But also, since the Great Depression, income tax cuts have occasionally been used as a form of economic stimulus when politicians realize (usually pretty late) a recession is underway. While such tax cuts might provide a small tailwind to growth in such a scenario-and aren't totally inappropriate policy-history shows cyclical factors swamp them. Therefore, it isn't so illogical that stocks fall more frequently when income tax rates are cut than hiked. Changes to corporate rates and long-term capital gains tax rates happen less frequently, but there is still no set relationship between tax changes and stocks' direction.

Ultimately, tax policy will create winners and losers. It can affect sentiment, both toward a candidate and markets generally. And it can impact the economy, to an extent. However, it is a mistake to overrate its importance. Remember always: Global markets are vast, flexible and complex. They adapt to widely known information near instantaneously, and tax debates are very widely followed. Not all investors are even subject to American tax: Some are retirement plans; others are non-US investors; still others institutions. Tax policy may be a big political issue, but for markets, it's not so huge at all, really.