By David Randall, Lewis Krauskopf and Stephen Culp
NEW YORK (Reuters) - Wall Street is skeptical President Joe Biden's expected proposal to hike capital gains taxes could pass the Senate, but investors see risks that tax-motivated selling could still weigh on technology and other sectors that skyrocketed during the pandemic.
Biden's proposal calls for increasing the top marginal income tax rate to 39.6% from 37%, and nearly doubling taxes on capital gains to 39.6% for people earning more than $1 million, according to sources familiar with the plan.
While any tax increase will likely be lower than Biden's initial proposal given the Democrat's small advantage in the Senate, individual investors who are concerned about rising rates may start to unload shares in order to lock in current rates.
That would disproportionately weigh on technology stocks such as Apple Inc (NASDAQ:AAPL), which is up more than 90% over the last year, and hot growth stocks like Tesla (NASDAQ:TSLA) Inc, whose shares have jumped nearly 400% since last April, said Steve Chiavarone, portfolio manager and equity strategist at Federated Hermes (NYSE:FHI).
"There's a lot of capital gains built into those names, and we think they would be the ones who are most likely to take it on the chin," Chiavarone said.
High-flying stocks such as Tesla fell nearly 3% on Thursday afternoon following reports of the Biden tax plan. Apple dropped 1%, while Facebook Inc (NASDAQ:FB) fell 1.5%. The broad S&P 500 dropped 0.9%.
The rally in the U.S. equity market since the start of the year will also likely prompt investors to pause until there is more clarity on the plan, said Oliver Pursche, senior vice president at Wealthspire Advisors in New York.
"Over the last few weeks, the market has shown itself to be out of breath. And this is one more reason for investors to take some profit," he said.
The S&P 500 is up 10.1% since the start of the year and trades at a price to earnings ratio of 29.9, a valuation level near its all-time highs.
"Some traders are looking for an excuse to lock-in profits and they might choose to use this tax story as their catalyst," said Ed Moya, senior analyst at FX brokerage OANDA, in a note.
Despite the declines in the stock market on Thursday, many on Wall Street do not expect capital gains taxes to rise substantially given that the Senate is divided with each party holding 50 seats and Vice President Kamala Harris acting as a tie-breaking vote.
"When you have a razor-thin Democratic majority in the Senate, in which if you lose one single senator, tax increases and the likes thereof aren't going to get through," said Burns McKinney, a portfolio manager at NFJ Investment Group in Dallas.
Should some capital gains tax increase pass, however, dividend-paying stocks could become more attractive.
"If you do have the capital gains tax go above and beyond that on dividends, it could actually end up favoring dividend-paying equities going forward," he said.
Qualified dividend income tax rates top out at 20%. The ProShares S&P Dividend Aristocrats ETF dipped 0.7% on Thursday, slightly less than the broader market.
A significant capital gains tax increase would also likely spur a wave of mergers and acquisitions, said Matthew Keator, managing partner in the Keator Group, a wealth management firm in Lenox, Massachusetts.
"People are going to want to seal in lower capital gains rates than they could see in the future," he said.
Still, the long-term outlook for U.S. equities remains positive, investors said.
Investors who do realize their capital gains now may find a hard time finding other attractive places to put it besides the equity market, said Paul Nolte, portfolio manager at Kingsview Investment Management in Chicago.
Thursday's sell-off is "not anything that is going to be a long-term disincentive to buy stocks," he said.