With the 2020 election behind us, investors can now consider the implications of voters’ decisions. The end result is a divided government, with the fate of the Senate hinging on recounts in Georgia while Democrats retain a majority in the House and have narrowly captured the presidency. While some observers fear a divided government may inevitably lead to gridlock, a more likely outcome is that President-elect Joe Biden and Senate GOP leader Mitch McConnell, who served together in the Senate for 25 years, will be able to meet each other halfway in a select few areas.
Spending is always an easy place to find compromise. A second COVID-19 relief package seems likely while the pandemic is still raging. The question to negotiate is the amount of relief and timing. It’s possible a bill could make it through Congress during the lame-duck session, but it’s also very possible it could be delayed until a new administration is installed in January. In either case we expect a Biden administration to request something in the neighborhood of $3 trillion. Their priorities include payroll protection, funds for testing and tracing, and aid for small business and state and local governments. Senate Republicans are likely to revert to a more fiscally conservative stance, offering something closer to $1 trillion focused on payroll protection and testing and tracing, with little or nothing for state and local governments. The two parties should be able to find a compromise, but only after a lengthy and heated argument.
The next most likely area of compromise will be tax increases and spending adjustments. Biden has laid out ambitious plans for increasing corporate taxes, raising the top individual tax rate, and requiring high earners to pay the same rate on investment income that they pay on wages. Republicans will likely focus on large structural deficits and the need to reduce spending, with entitlement programs like Social Security and Medicaid their main targets. It’s unlikely either of these programs will be touched and more likely that less high-profile discretionary programs, like agriculture and housing, experience a decline in growth. The potential for a deal is there, but getting it across the finish line will be painful, requiring compromise on both sides.
Health care is one area where compromise is likely to remain out of reach. Biden has proposed strengthening the Affordable Care Act (ACA) through the addition of a public option and extension of more low-cost tax credits to low-income families. Republicans have spent the last decade trying to eliminate the ACA through legislation, lawsuits, and executive action. It’s hard to expect Senate Republicans to support legislation that enhances the ACA in any material way. It’s more likely that a Biden administration reverses some of the Trump administration’s executive orders and terminates Department of Justice support for lawsuits adverse to the ACA.
Now that we’ve set the stage for the changes that are expected to take place under the mixed majority, let’s look at how they’ll impact investors.
Taxable investors will get some breathing room as Biden settles in
There’s plenty of uncertainty about the future of tax policy and the details of what, if any, part of Biden’s proposed tax plan can make it through the Senate. Investors wondered in the weeks leading up to the vote whether to anticipate further tax cuts under Trump or potential tax increases under Biden. Given other pressing matters, such as the ongoing COVID-19 pandemic and its economic effects, it’s unlikely that any changes to tax policy will be implemented early in 2021. It’s more likely that after months of addressing other issues, some form of tax policy could be passed in mid- to late 2021 and put into effect in 2022.
Biden’s proposals included increasing the highest marginal tax rate from 37% to 39.6%, eliminating the preferential treatment for long-term gains and dividends for those earning more than $1 million, and eliminating the step-up in cost basis upon death. It’s anyone’s guess if or when his administration will put these proposals forward and how they’ll need to be modified to gain approval in the Senate. Many believe some type of tax bill that includes some subset of these rate increases could be passed in 2021, with the change going into effect in 2022. However, although still considered less likely, there’s a chance that some tax increases pass in 2021 and are retroactively applied to January 1. Investors who believe this to be a probable scenario will need to quickly assess whether they should strategically realize gains in the current tax year to avoid a higher tax rate in the future.
A mixed bag for muni investors and little change for the corporate market
Senate Republicans are likely to perform an obstructionist role not dissimilar to the way they operated during the second term of the Obama administration. Elements of the Biden agenda relevant to the municipal bond market that we believe are likely to be enacted are corporate and personal income tax increases, a revision in the deduction cap for state and local taxes (SALT), and possibly some form of infrastructure plan. The outcome should provide a tailwind for the municipal bond market.
We anticipate the top personal income tax bracket reverting to 39.6% and some increase in the top corporate tax bracket, though not the 28% that Biden has proposed. This should increase demand for municipals from wealthy investors, banks, insurance companies, and other nonfinancial institutions. An offsetting factor on the demand side would be a possible revision to the SALT deduction cap.
Biden has a proposed $2 trillion infrastructure plan, which includes incentives for debt issuance for infrastructure projects. The Trump administration failed to advance any infrastructure program despite widespread bipartisan support for the idea. With new political dynamics in Washington, we believe a scaled-down version of the Biden plan could pass. As part of any package, we might see reintroduction of Build America Bonds and an expansion of Private Activity Bonds. This may increase municipal supply in general, but it could significantly expand the already growing taxable muni market, which may see more participants, better liquidity, and more opportunities to apply investment strategies such as laddering or relative value trading.
From a corporate market standpoint, we don’t anticipate a dramatic shift in demand, supply, or credit fundamentals. The Democratic victory offers the likelihood of less uncertainty regarding trade and stimulus policies. Investment-grade fund flows were consistently positive going into the election, which is an indication that investors aren’t overly concerned that the election results will materially impact credit spreads.