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Dilantha De Silva
Dilantha De Silva
Articles (182)  | Author's Website |

Implications of the Proposed Tax Hikes

Investors need not panic, but should closely monitor new developments

January 20, 2021 | About:

Government policy decisions can often lead to significant changes in corporate earnings, thereby affecting stock prices in both the short and long run. For this reason, it is important to keep a close eye on expected changes, especially when it comes to the corporate or personal income tax rate.

With the ongoing pandemic and the current economic situation, tax hikes will likely be needed if the U.S. government wishes to keep its programs funded. Additionally, with Democrats controlling both the Senate and the House, the probability of a tax hike is high going by the proposals of the new administration.

Thus, investors should prepare themselves for higher taxes not only by assessing the impact on their income but also by carefully evaluating the negative or positive impacts these policy changes will have on stock prices.

A summary of expected tax hikes

According to the official website for the Joe Biden campaign, the administration plans to propose three major changes to the tax policy:

  1. Raising the marginal income tax rate from 37% to 39.6% for individuals with an annual income of over $400,000.
  2. Raising the corporate tax rate from 21% to 28%.
  3. Taxing long-term capital gains at the personal income tax rate of 39.6% on income above $1 million.

Additionally, the Trump administration has already built tax increases into the tax code for those with incomes of $75,000 and under. As part of the 2017 Tax Cuts and Jobs Act, those making less than $75,000 per year (approximately 65% of Americans) will face incremental tax hikes from 2021 to 2027.

Even though all these factors are equally important, and some of them will doubless affect nearly every investor in the markets, the focus of this article is on identifying the market impact resulting from the proposed increase of the corporate tax rate.

Expected tax hit

The negative impact resulting from expected tax hikes would be felt by all companies to a varying degree. According to Bank of America (NYSE:BAC) analysts, the technology sector will see the biggest decline in earnings if the tax rate increases.

S&P 500 sector

Expected impact on earnings

Technology

-9.2%

Health care

-8.4%

Communication services

-8.2%

Consumer discretionary

-7.5%

Financial services

-6.5%

Source: CNBC/BofA Securities

There is a lot of uncertainty, but the data in the above table can be used as a starting point to understand which sectors will be impacted the most if the new administration decides to go ahead with the planned tax hikes.

It's a matter of when not if

A thorough evaluation of macro-economic conditions reveals that the U.S. government will almost certainly be forced to increase corporate taxes in the coming years if it wants to avoid a disaster. The fiscal deficit surpassed $3 trillion in 2020, and this is uncharted territory. The deficit is approximately double the peak reported during the global financial crisis, which goes on to show the devastating impact of the Covid-19 recession.

Source: Datalab USA Spending

Rupal Bhansali, the Chief Investment Officer of Ariel Investments, was part of the Barron's Roundtable this year, and answering a question from a panelist regarding the outlook for the American economy, she said:

"As for the corporate tax rate, there is no other way but up, given record budget deficits in the U.S. That isn't priced into U.S. stocks at all. Higher taxes are less of a risk for international markets. All of this bodes poorly for the U.S. dollar. Money was attracted to the U.S. because the stock market performed well and a strong dollar added an extra boost. The currency trend is likely to reverse. That means international assets may do better than domestic assets in the future. That's a big reset, compared with the past decade."

The portfolio manager is convinced that taxes will be raised at some point, but this might not happen this year. Federal and monetary policymakers are currently trying to revive the American economy using a plethora of quantitative easing tools. The government, on the other hand, has injected trillions of dollars into the economy, and the Biden administration announced a $1.9 trillion stimulus package on Jan. 15 to boost business activities.

An increase in taxes will have a counter effect on what policymakers are trying to achieve with these actions, so I believe the proposed changes are highly unlikely to come into effect in the first half of this year. In the base-case scenario, I think tax hikes are likely to be postponed at least through mid-2022.

Dividends and buybacks might come under pressure

The Tax Cuts and Jobs Act that was passed in 2017 saved corporate America billions of tax dollars, and many mature companies decided to pass on some of these savings to their shareholders by way of dividends and stock buybacks. The below chart illustrates how cash allocated to shareholder distributions increased dramatically in 2018 following the tax cuts.

Source: Portfolio Wealth Global

A reversal of this trend was triggered last year when companies had to trim their dividends to improve liquidity, and this trend will likely accelerate in the long run as a result of the expected tax hikes. Income investing, therefore, will not be as easy as it was over the last few years, and looking for opportunities in growing international markets might prove to be a better strategy.

Learning from the history books

History might not repeat itself, but analyzing certain macroeconomic events and the market reactions to such developments is a good way to gauge a measure of how the market is most likely to behave in the future.

Fidelity conducted a study with data going back to 1950 to determine the impact of tax hikes on stock prices. Surprisingly, this research paper concluded that the market tends to shrug off tax hikes. The below illustration by Fidelity confirms this.

Source: Fidelity

Even when personal, corporate and capital gains taxes were all increased in 1968 and 1993, the S&P 500 delivered positive returns, suggesting the market movements were determined by an even stronger external influence. Tax hikes often lead to increased spending by the government or might even come after a period in which the government injected money to stimulate economic activities. Therefore, the positive returns associated with tax hikes can be explained by using the concept of marginal costs to the economy. In other words, if investors believe the negative impact resulting from an increase in taxes is more than offset by the positive impact resulting from higher government spending, the market is likely to head higher. This proves the importance of looking at the big picture, not just a single macroeconomic variable.

Takeaway

Changes to the tax policy need to be carefully monitored to identify inflection points. However, there is no reason to panic, and empirical evidence confirms this. Income investors might have to revisit their strategy to better prepare themselves for some negative developments, and the initial market reaction could turn out to be negative. With no control over macroeconomic policies, retail investors should ideally focus on identifying companies that are well-positioned to thrive despite unfavorable changes to the tax policy.

Disclosure: The author does not own any shares mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\\\'m a CFA level 3 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

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