Economic commentary: Can the equity bull market survive tax hikes?

Global equities, led by the US, have staged an impressive rebound from the pandemic lows of 2020. Since global equity markets bottomed out on 23^rd March 2020, the iShares MSCI all-country world ETF has gained 83%¹, as US equities – which typically make up around 60% of global equity indices² – have risen over 92%. This stellar rally has been fuelled by unprecedented stimulus from governments and central banks, along with a bounce-back in economic activity facilitated by the rollout of vaccination programmes.

However, with the major advanced nations now emerging from the crisis, the fiscal narrative is starting to shift. Whereas emergency relief spending during the pandemic was funded by the issuance of debt, governments on both sides of the Atlantic are now looking to raise taxes, either to repair battered public finances or to finance post-covid ‘build back better’ programmes.

In the US, the administration of President Joe Biden has recently announced plans to hike taxes on corporations and wealthy households to help pay for increased spending on both physical and social infrastructure programmes.

Against this backdrop, there is understandable concern amongst investors that proposed increases in corporation tax and capital gains tax (CGT) could derail the current bull market in equities.

How might increases in taxes impact stock market performance?

Corporation tax

Take corporation tax first. President Biden’s “Made in America Tax Plan” seeks to incentivise job creation and investment in the US, stop unfair profit shifting to tax havens, and ensure that large corporations “pay their fair share of taxes” ³. To do so, the administration has proposed several measures: an increase in the corporate tax rate from 21% to 28%; a 15% minimum tax on book income; a global minimum tax of 21% on foreign income of US corporations; and the elimination of tax loopholes on foreign income derived from intangible assets such as intellectual property ⁴.

These measures will weigh on the after-tax earnings of US corporations. Goldman Sachs estimate that Biden’s tax proposals could reduce the earnings per share of companies in the S&P500 by 9% in their first year of implementation ⁵. Companies with large foreign earnings, notably those in the technology and communication services sectors, are seen taking the biggest hit.

Lower earnings could potentially lead to a reduction in business investment, dividend payouts and share buybacks. However, historically low borrowing costs and elevated corporate cash piles should serve to mitigate the impact of higher tax bills. According to figures from JP Morgan, non-financial S&P500 companies were sitting on cash balances of US$2.1 trillion in the fourth quarter of 2020⁶. And with S&P500 profits having grown by around 50% year-on-year during the first quarter of 2021, this figure is likely to have risen further⁷.

As regards the impact on stock market performance, there is scant evidence to suggest that an increase in the corporate tax rate, in and of itself, ushers in a period of negative returns. On the contrary, analysis by LPL Financial of various tax hikes that took place between 1940 and 1993 indicate that US equities on average post positive returns during the months leading up to and the months after an increase⁸. On average, the S&P500 posted a positive return of around 4% during the 12 months after the tax rise.

More generally, the prevailing rate of corporate tax is a poor guide to stock market performance. This is because the state of the economy, the stance of monetary policy and industry-specific factors tend to be bigger drivers of market performance.  

Indeed, as the proposed increase in corporation tax will partially fund President Biden’s US$2 trillion infrastructure spending plan, some of the revenues raised will flow back to US corporations, boosting their revenues and profits. This said, tax hikes are likely to come in to force before infrastructure projects are rolled out, which suggests that corporate America will face higher tax bills before it sees the benefit of increased spending.

What’s more, when the net effects of both expenditure and taxation are taken into account, there will be winners and losers. Companies operating in the materials, construction and engineering sectors are likely to be direct beneficiaries of higher infrastructure spending, while the technology sector is likely to see a larger-than-average increase in tax.

At the broad macro level, a period of relatively strong GDP growth, as the economy bounces back from the pandemic and monetary policy from the Federal Reserve remains accommodative, should be supportive of corporate earnings and equity markets.

Capital gains tax

Another aspect of the Biden plan which has unnerved investors has been a proposed increase in capital gains tax (CGT).  Under current proposals, households earning over US$1.0 million year — the top 0.3% of all households —will see their tax rate on capital gains nearly double from 20% to 39.6%⁹.

Over the longer term, it might be argued that a higher rate of CGT would restrict the mobility of capital between investments if investors are incentivised not to sell assets and realise capital gains. A higher rate of CGT might also dampen incentives and lead to a reduction in levels of entrepreneurship. In addition, by lowering the post-tax return on investment, a higher tax on capital gains could increase companies’ cost of capital¹⁰. All of these factors could potentially dampen growth in the economy and corporate profits over the long term.

In the near term, the concern is that wealthy investors will bring forward asset sales to avoid paying a higher rate of tax in the future. If there is enough selling concentrated in a short period of time, this could put downward pressure on the market. Again, the potential hit is likely to vary across sectors. One would expect that the parts of the market that have seen the largest price gains in recent years, most notably the tech sector, to be most vulnerable in this regard.

History does point to some evidence of pre-emptive selling exerting downward pressure on the equity market in the period leading up to an increase in CGT. Analysis from LPL Financial indicates that during the last four hikes in CGT (in 1969, 1976, 1986 and 2013) the S&P 500 posted an average negative return of 0.1% during the three months prior to the hike¹¹. However, the good news is that once the tax increase is out of the way, the equity market has generally tended to rally. For example, after the CGT tax hike in January 2013, the US equity market went on to return over 25% that year.

A change in market leadership?

It should be remembered that Biden’s tax and spending proposals are subject to congressional approval, and given that the Democrats have only the slimmest of majorities in the Senate, there is a good chance they will be watered down. Press reports suggest that the corporate tax rate could ultimately be raised to 25% rather than the 28% initially proposed¹². There could also be compromise around the CGT increase.

All things considered, the Biden tax hikes, in and of themselves, appear unlikely to derail the bull market in US equities. Even with higher taxes, equities will still be relatively attractive versus bonds. This said, as we have seen, there are likely to be implications for the performance of specific sectors. The tech sector stands out as a loser, both from the proposed increase in corporate tax and as a potential target of pre-emptive selling ahead of any increase in CGT. In this regard, the tax changes could reinforce this year’s rotation towards cyclical/value sectors of the market and away from so-called growth areas¹³. This rotation has primarily been driven by the vaccine-fuelled economic recovery and a rise in government bond yields, but it could be given a further boost from the Biden tax changes. Having benefitted greatly last year from pandemic-related changes in spending patterns, the tech sector has underperformed so far in 2021, as economies have reopened. In turn, from a geographical perspective, the high weighting of the tech sector in the American market has meant that the US equity market has underperformed those of the UK and the eurozone so far this year. The tax headwind facing US equities might mean that this trend continues.

17^th May 2021