In the aftermath of drafting the US Constitution, Benjamin Franklin wrote, “… in this world nothing can be said to be certain, except death and taxes”. For individuals such as you and me, this is the truth. However, American corporations have the privilege of existing into perpetuity, leaving only taxes as their only remaining certainty. It’s no wonder why taxes can be such a big influence in how we value a company. Taxes are something every corporation needs to deal with. Even if they don’t pay any taxes, they still need to figure out how not to pay their taxes. With this in mind, we consider one of the tax increases within President Biden’s recent budget proposal; the corporate tax hike to 28%.
Traditional thinking around corporate taxes goes something like this. If taxes increase for a company, there are fewer dollars for that company to spend on projects, reducing the company’s potential profitability, causing the company’s stock to perform worse than had taxes not increased. It seems intuitive and straightforward. However, if there’s one thing that’s not intuitive and straightforward in this country, it’s our tax code. Companies can benefit significantly from deductions and expensing future business investments today, allowing these companies to pay considerably less than the headline corporate tax rate.
Using Recent History as a Guidepost
We have a recent example with which to base this idea, albeit in the form of a tax cut, with the Tax Cuts and Jobs Act (TCJA) of 2018. The bill reduced the headline corporate tax rate from 35% to 21% and provided a tax holiday for companies to repatriate cash they held overseas. During 2018, it’s estimated that US corporations saved $95 billion in taxes (or roughly 0.5% of US GDP) and repatriated an additional $340 billion from overseas holdings that were previously untaxed by the USA. However, as the chart below shows, companies generally spent much less on business investment than one would expect based on the amount they saved during this time. If taxes fell, shouldn’t capital expenditures commensurately increase as well? It would appear there are other factors at play than simply reducing headline tax rates.
Getting back to the nuances of the American tax code, within the TCJA, there were also limitations on the tax-deductibility of interest payments (a net negative) and equipment expensing provisions that are set to phase out in 2023. Often when tax benefits have a phase-out period, companies will adjust for this in their business planning and not spend as much as they would have if the benefits were assumed to be permanent. Said differently, even though the headline rate fell by 14 points, corporations were more attuned to the details of the longer-term outlook for the tax code changes (and the economy) and planed their spending accordingly.
More specifically, as it relates to the President’s budget proposal, it would appear an increase from 21% to 28% would have a similarly limited effect on a business’s capital expenditures. Additionally, given the thin margins by which democrats control the House and Senate, it appears unlikely a hike to 28% could pass through Congress. If a bill were to pass, our expectation would include the corporate tax rate increasing to 25%, representing a modest 4% increase from current rates. Because this specific tax increase is still being debated, the nuances of tax law changes will likely be more important to understanding how any tax increase could affect corporate spending.
Impact on International Competitiveness
Some may fear the effect raising tax rates has on corporate competitiveness abroad. Indeed, before the TCJA, America’s corporate tax rate was the third-highest among 30 developed and emerging economies. After the tax cuts in 2018, American corporations enjoyed tax rates approximately on par with the GDP-weighted global average. However, as we mentioned earlier, companies are more concerned with the nuances of the tax law. Thus, looking at the average marginal tax rate may be more applicable to American competitiveness. (Note – The marginal tax rate is defined as the tax rate paid on the next dollar of income. This is useful as it adjusts for deductions companies can make to reduce their total taxes paid). To wit, the Organization for Economic Cooperation and Development (OECD) estimates American companies had an 11% effective marginal tax rate for 2019, which also put the US on par with other developed nations. If we assume the headline corporate rate to only increase by 4%, we can assume the marginal rate to rise proportionately less.
Could Stock Performance be at Risk?
So what could this all mean for US stock market performance? In a fundamental sense, not much. According to JP Morgan research, they estimate a 25% corporate tax rate could lower earnings per share (EPS) of S&P 500 companies by approximately $5 over the next twelve months. To put this into context, current estimates show EPS for 2022 to be around $204. Assuming these estimates hold, 2022 EPS of $199 still represents a 10.5% growth rate from 2021 estimates of $180 for all S&P 500 stocks. The health of corporate America is in great shape these days and would likely take a modest tax increase in stride without adjusting plans for current capital expenditures. This isn’t to say some companies may be impacted disproportionately to others and could impact spending and hiring practices. However, this wouldn’t be known for some time after any increases go into effect.
We’ve seen how dramatic tax cuts have had modest impacts on business spending and reinvestment. What tends to matter more to companies and their stock performance is the economic environment and its outlook. With the aggressive monetary and fiscal spending that has emerged since the beginning of the pandemic, we’re set to see one of the fastest expansions of domestic GDP in decades. We anticipate this will matter much more for stock performance than a relatively small increase in the headline corporate tax rate.
Bernicke does not make any representations as to the accuracy, timeliness, suitability, or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes, and all uses thereof should be guided accordingly.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor, Great Valley Advisor Group, and Bernicke Wealth Management are separate entities from LPL Financial.