The federal government is on track to continue a spending spree that’s injected trillions of dollars into the economy, but investors may soon be bracing for the T-word.
Taxes, specifically corporate tax hikes, are likely to work their way on to the radar screen as President Joe Biden prepares what’s expected to be a multitrillion dollar package of infrastructure spending.
So is it time for stock-market investors to head for the hills? Not quite.
In fact, it might be difficult to discern the impact of tax-hike worries because the potential impact “will look somewhat similar to the cyclical reflation we see right now,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments, in an interview. She was referring to the rotation away from previously high-flying growth stocks toward more economically sensitive cyclical stocks.
Growth stocks — shares of companies whose revenue and earnings are expected to grow faster than their peers — are seen as the most vulnerable to rising tax rates. Growth stocks, which soared through much of the pandemic, are feeling pressure from rising bond yields, which make it more difficult for investors to justify their lofty valuations.
The past week saw the tech-heavy Nasdaq Composite
slip 0.58%, leaving it up just 1.94% for the year. The S&P 500
saw a weekly rise of 1.57%, while the Dow Jones Industrial Average
edged up 1.36%. The S&P 500 remains up 5.82% for the year, while the Dow is up 8.06%.
So what’s on the table? A partial unwinding of the 2017 corporate tax cut, which lowered the rate from 35% to 21%, is seen as the most likely outcome. A rise in the top personal income tax rate and an overhaul of the estate tax are also potential candidates. More ambitious measures on Democrats’ wish list include a wealth tax and a hike in the capital gains tax rate.
The Biden administration has yet to roll out a full-fledged plan for infrastructure spending or any accompanying tax increases. During the presidential campaign, Biden called for raising the corporate tax rate on domestic income to 28%, while also raising the tax rate on foreign income, known as the GILTI tax, and instituting a minimum corporate tax rate.
A 28% tax rate would clip corporate earnings by 9% in 2022, estimated equity analysts led by David Kostin at Goldman Sachs, in a March 19 research note.
Goldman’s economists, however, expect Congress to pass a smaller increase, Kostin and company noted. The analysts, therefore, look for a hike in the corporate tax rate to 25%, which they estimate would result in a 3% drag on earnings. A bigger hike, or the passage of other measures like an increase in the tax rate on foreign income are a downside risk to that estimate, they said.
David Lefkowitz, head of equities Americas at UBS Financial Services, undertook a similar exercise. He also penciled in a corporate tax rate of 25%, which he estimated would be a 4% drag on 2022 earnings.
“This is embedded in our expectations for 13% growth in S&P 500 [earnings per share] in 2022,” he said in a Thursday note. “If the corporate tax rate remains unchanged, earnings could grow closer to 17%. Higher corporate taxes could be a modest drag on equity markets, but U.S. companies should still produce healthy profit growth.”
Investors should also bear in mind that tax increases will be used to at least partially pay for infrastructure spending, “which would tend to boost economic growth and
offset some of the drag from higher taxes,” he said.
A breakdown of the potential earnings impact underlines the bigger threat posed to more growth-oriented sectors. According to Goldman’s analysis, the communications services and tech sectors face the biggest hit to earnings from increases in the corporate tax rate and the tax on foreign income, while the more cyclically oriented industrials, energy and materials sector are at the bottom. The picture changes, however, depending on the mix (see chart below).