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By Nisha Patel, CFADirector Fixed Income, Portfolio Management, Parametric

New York - Four weeks away from the US presidential election, the potential tax policy changes by a Biden-Harris administration would represent a significant departure from the status quo, as we have discussed in previous blogs. So it stands to reason that investors in fixed income separately managed accounts (SMAs) should consider what might happen if there is a new resident of the White House in 2021.

The municipal market is particularly sensitive to tax rate changes, especially tax increases. Starting in 2017, for example, the Tax Cuts and Jobs Act (TCJA) reduced the top federal income tax bracket from 39.6% to 37%. Nevertheless, high-net-worth investors sought muni bond exposure because the TCJA also limited the deductibility of state and local taxes (SALT).

Biden changes tax policy

Under a Biden presidency — and particularly under Democratic control of Congress — a proposed reversion to the 39.6% income tax bracket for the highest earners could increase demand for municipal bonds. That might result in lower yields and higher prices — thus increasing their value for existing investors.

The SALT cap could also be repealed, and this would be a positive for muni investors. However, with the individual tax rate returning to its pre-Trump level, the actual effect on bond prices or yields would likely be negligible.

Another significant change involves Biden's proposal to increase the corporate tax rate to 28%. This may lead corporations to add some muni exposure. Although that corporate rate wouldn't be as high as in the pre-TCJA era, we believe the increase in demand from corporations may result in price appreciation for existing bonds.

Lastly, the ability of fixed income SMAs to harvest tax losses1 on a year-round basis could prove to be beneficial for high-tax-bracket investors seeking to offset gains. Biden's proposal for all capital gains to be taxed as ordinary income for those earning more than $1 million may lead these investors to further seek out tax-loss harvesting options.

Democrats take control

If Democrats end up controlling both chambers of Congress, we could see an effective tax regime change in 2021. However, the consensus is that in light of the economic impact of the 2020 health crisis, a significant tax bill would likely take a backseat to COVID-19 recovery and other stimulus. Tax policy changes could take most of next year to complete and would likely have an effective date at the beginning of 2022.

Bottom line: Under a second Trump term, muni demand would remain high due to the current SALT cap and the low chances of further tax reductions for individuals. However, tax-exempt investors may have more to gain under a Biden presidency, since the likelihood of individual or corporate tax rate increases could improve the relative value of their fixed income holdings and increase the demand for tax-exempt investments.

1 Tax loss harvesting is a strategy for managing taxes in an investment portfolio. Selling a security that's trading at a loss creates a realized tax loss, which can be used to offset a capital gain realized in the same year.

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