The Biden administration is set to raise corporate taxes as part of the $2.25 trillion American Jobs Plan, which seeks to raise $2 trillion in tax revenue over 10 years in order to fund the new infrastructure-focused spending package.
This involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income.”
In addition, as part of the $1.8 trillion American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group.
We have the following observations of the potential market and economic impact of these proposals and potential tax increases.
Impact of Higher Corporate Taxes
Raising the domestic corporate income tax rate from 21% to 28% would bring the tax rate halfway back to where it was prior to the
2017 Trump tax cuts (35%). Accounting for international corporate profits and other factors, estimates show this tax hike would reduce S&P 500 earnings by about 4%.
The higher minimum tax on foreign profits would reduce S&P 500 earnings by about another 3.5%. Major technology and healthcare firms with significant international operations would see the greatest impact from these measures.
The 15% minimum tax on “book income” (i.e., the earnings that companies report to shareholders) would apply to corporations with annual profits in excess of $2 billion. The Treasury department estimates that 45 companies would be liable for this tax. It would cut S&P 500 earnings by a further 0.5%.
In total, these provisions would reduce S&P 500 earnings by about 8%. However, these preliminary numbers are very likely to change with several centrist Democrats already suggesting they prefer a smaller corporate rate increase. The plan also includes a variety of tax credits, focusing on areas such as clean energy and Research & Development, which would offset some of the tax increases. In addition, the increased spending on infrastructure and other items would boost economic activity, providing an offset to higher taxes.
Importantly, the strong economic recovery we are now experiencing is also a dominant factor for corporate profitability and stocks. Corporate profits are now expected to rise by 33% in 2021 and a further 10% in 2022. This robust profit growth, fueled by a synchronized global recovery that’s unfolding, provides a positive backdrop for absorbing higher corporate taxes.
Impact of Higher Personal Taxes
Considering Biden’s proposal
would take the capital gains tax rate to the highest levels since the 1970s, we view it as more significant than the modest proposed change to the top marginal income tax rate for higher income households. However, history suggests equity selling later
this year ahead of a possible capital gains tax hike will be short-lived and reversed in subsequent quarters.
We view the probability of a retroactive tax hike as unlikely—budget rules require long-term offsets to new spending, but not in the near term, and retroactive tax increases could reduce political support for future fiscal packages. We also think the final capital gains rate will likely be negotiated lower.
Past capital gains tax hikes have been associated with declines in stock prices and in household equity allocations. However, the trend of equity selling and falling stock prices around capital gains rate changes has usually been short-lived and reversed during subsequent quarters. In 2013, although the wealthiest households sold 1% of their assets prior to the rate hike, they bought 4% of starting equity assets in the quarter after the change and therefore only temporarily reduced their equity exposures in order to realize preceding capital gains tax hikes.
History also shows that high-momentum “winners” that had delivered the largest gains to investors ahead of the rate hike have usually lagged the broader market. Technology and Consumer Discretionary sectors have been the largest sources of capital gains within the U.S. equity market during the last 3, 5, and 10 years.
Impact on Economic Sectors
The new spending proposals, with an emphasis on infrastructure, are beneficial for cyclical sectors
tied to infrastructure spending such as Energy, Materials, & Industrials (Construction / Engineering). These sectors also have significant carry-forward losses, particularly after COVID-19 related losses, and should be able to shield some of the initial
higher tax burden. They are also major beneficiaries of the economic reopening and are showing robust profit growth.
Financials, particularly Regional Banks, should see a multi-year benefit from infrastructure spending and is a major beneficiary of improving economic growth and associated higher long-term Treasury yields. However, this mostly domestic sector should see a sharply higher effective tax rate given limited foreign tax shelters (effective tax rate declined to ~22% from ~32% after Trump’s 2017 tax cuts).
The higher taxes on international profits would target asset-light multinationals with significant intellectual property, low tangible assets, high foreign revenues and low effective tax rates. The sectors most vulnerable include Technology / Communication Services (Software, Semiconductors, Tech Hardware, Communication Equipment, Internet Services, Media), and Health Care (Pharma / Biotech).
In summary, we remain encouraged by the robust synchronized global recovery that is unfolding as the economy reopens and the pandemic fades with vaccines. This recovery is supporting very strong corporate profit growth that should enable stocks to absorb the impact from potentially higher taxes. The higher spending associated with Biden’s proposals would also boost economic activity and cushion the effect of higher taxes. Financials, Energy, Materials, and Industrials remain well positioned for the economic recovery.
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