Ahead of most US Presidential elections, stock markets usually become more volatile as investors weigh various economic and policy outcomes. At first glance, the upcoming election poses a stark choice on a subject that typically matters a great deal to investors – corporate income taxes. Many observers appear to believe increased taxes will drive stock prices down, perhaps dramatically.
This is probably not sound thinking.
That’s because, in all probability, US tax policy won’t change corporate earnings very much. To be sure, Vice President Biden is on the record advocating a hike in the federal corporate income tax rate from 21% to 28%. President Trump had slashed the rate from 35%, a move that contributed to healthy gains in after-tax US earnings and robust stock price performance in 2018.
Yet before exploring the potential implications of a Biden tax increase, it is important to emphasize that in a possible second term, President Trump would be unable to further reduce corporate income taxes. After a pandemic that has cost the federal government trillions of dollars in relief spending and lost revenues, major tax cuts will be out of reach. Perhaps for that reason, concrete details on a rumored Republican tax cuts have never really emerged.
As for the Biden plan, it is worth examining in detail the earnings impact of a hike in the rate to 28%. According to consensus estimates for companies that will face the full rate increase, after-tax earnings would fall 8.8%. But many companies will see a smaller tax bite. Goldman Sachs consumer stock analysts, for example, suggest the earnings impact would be about 6% for stocks in their coverage universe, with the average effective tax rate rising to 24% from 20%.
One of the major drivers of the effective rate is the share of overseas earnings – the more internationally exposed a company, the smaller the real tax increase it will experience.
Smaller companies with domestic-only revenues would see their effective tax rates increase by more, with after-tax income estimated to decline by 8%. Larger companies, which typically have more international exposure, would experience a smaller impact. For example, Procter and Gamble, which derives more than half of its revenue overseas, would see its effective tax rate rise from 18.5% to 21%, cutting its after-tax profits by about 3%. Other large global companies, such as Nike, McDonalds or Wynn Resorts, would likely suffer only a 1% drop in after-tax income profits. For investors in major US indices, such as the S&P500 that derives nearly 40% of their revenues abroad, higher corporate tax rates will probably be secondary to other factors in driving share price performance.
Moreover, if the election produces divided government, with Republicans retaining control of the Senate, then it may be politically impossible to lift the federal corporate income tax rate to 28%. Recent polls indicate the odds that the Democrats wrest control of the Senate are around 50%. And even if the Democrats wrest a majority in the Senate, a few centrist Democrats could push for compromise on a smaller increase.
It is also not a given that corporate taxes will be a priority for Democrats. So long as the pandemic rages, unemployment remains high and the economy is vulnerable, a Biden Administration may prioritize health issues and economic stabilization over tax policy, reducing the probability of a big corporate income tax hike.
Rather, the outlook for growth will be the key driver of market performance next year. If the pandemic induces a new slump in the real economy, then no matter the tax rate, stock markets will decline. Similarly, if the economy revives, the stock market can rally further even in the face of higher corporate tax rates.
Finally, adjusted for historically low bond yields, equity valuations are not terribly demanding. The average forward one-year earnings multiple on the S&P 500 is about 21 times. That’s higher than the long-term average of 16.5 times, but compared to rock-bottom interest rates, stocks are not overpriced, even if they are not a bargain.
What’s the bottom line?
Investors should take into account all the factors that impact earnings and valuations, and hence likely market performance. Corporate tax rates matter, but they are only one factor and, today, not the most important. To be sure, higher corporate tax rates will not treat all companies equally. Smaller capitalization, domestically oriented stocks would, all else equal, fare more poorly, continuing a decade-long trend of large capitalization outperformance.
But if the last four years of the Trump Administration and more recently the pandemic have taught us anything, it is that basing investment decisions on ‘all else equal’ is risky. Rather than obsess over tax rates, investors should consider more broadly how economic, policy and political factors will shape the market outlook in the years ahead.
