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The Democratic National Convention continues this week. Investors are worried that a Democratic win would pressure the stock market by enabling substantial tax increases. The concern is valid, but economists at Morgan Stanley think it’s overdone.

Key quotes

“Keep in mind that Democrats winning the White House is far from a sufficient condition to raise taxes. They likely must also take control of the Senate. The Republicans convention is next week, and their party platform is likely to affirm that they prefer corporate taxes to stay the same; hence a Democratic tax plan likely requires control of both the White House and Congress. Polls suggest this is a meaningful possibility, but far from a given.”

“In a sweep, Senate control will come from key wins by moderates, building on the existing moderate cohort who helped swing control of the House of Representatives to the Democrats in the 2018 midterms. This group is less likely to support the full array of tax hikes proposed by the Biden campaign. That’s important because Senate control is likely to be slim, and so losing the support of just one or two moderates can sink legislation, giving them the power to influence what it ultimately looks like.”

“Full implementation could reduce S&P 500 earnings by 9%, but a watered-down version could get moderate Democratic Senate votes, would reduce earnings by only about 4%. A 4% hit to earnings from tax increases doesn’t account for a number of factors that could easily offset this impact, such as a more aggressive spending agenda that outstrips taxes and increases aggregate economic demand in the short term. This is something we would expect in a sweep.”

“There’s a nonpolitical factor that can dwarf this entire debate: the trajectory of the COVID 19 pandemic in the coming months. If the US continues making progress towards a vaccine, as our colleagues expect, then we don’t see enough reliable political risk to tell investors to take their own risk down.”