Few people, accountants excluded, like taxes. With some form of tax change in the winds, we take a brief look at previous tax increases to see the market reactions, and we provide our thoughts on positioning in the current environment.
In recent weeks, the Biden administration has unveiled a series of tax hike proposals to fund aggressive spending goals. The most significant elements of Biden’s tax proposals are as follows¹:
- Raising the top marginal income tax rate from 37.0% to 39.6%
- Raising corporate taxes from 21.0% to 28.0% and returning to a worldwide tax system (where foreign profits are included in the domestic tax base)
- Taxing long-term capital gains at the ordinary income-tax rate of 39.6% on income above $1 million
It’s important to note that these proposals are a starting point for debate and negotiation and ultimately need to be passed by Congress. The political strategists in our network see some elements of the tax plan as more likely to pass than others, with a higher corporate tax rate (most likely 25%, not 28%) and return to a worldwide tax system most likely, and capital gains tax increases less likely.
Higher corporate tax rates could dent earnings growth, but it’s not the end of the world
In our view, higher corporate tax rates would have a bigger impact than higher personal tax rates on stocks. This is because higher taxes can shrink margins and put pressure on corporate profitability. We did some math to determine how a range of potential tax increases from 3% to 8% (the range of forecasts from our network) might affect 2022 earnings estimates. This is based on current analyst estimates for 2022 S&P 500 Index earnings of 210.08.²
- Bull case 3% increase in corporate taxes 203.78
- Base case 5% increase in corporate taxes 199.58
- Bear case 8% increase in corporate taxes 193.27³
If the S&P 500 Index price to earnings in 2021 stays at roughly 22x, this would suggest S&P 500 Index prices should be around 4,483 bull case, 4,390 base case, or 4,251 bear case.
Higher taxes could also slow the improvement in the U.S. labor market. As taxes go up, executives often need to consider changes to corporate strategy. As margins get hit, it increases the need to manage costs, and employment is typically the largest component across a cost structure. The risk is that as tax rates go up, companies may not fully restaff because of margin concerns.
In our view, these factors may put modest pressure on stocks; however, corporate fundamentals continue to improve in spectacular fashion. Next 12-month earnings per share estimates for the S&P 500 Index just ticked up to $196.39² from a low of $141.99 a year ago. If earnings estimates continue to improve at this pace, tax increases might feel more like a scratch than a dent.
Capital gains taxes could alter investor behavior
Biden’s proposal is to tax investment income at ordinary rates for those who earn more than $1 million in total (wage and investment) income. While we don’t expect this to have a major impact on markets—as stocks will still be among the few options available for capital appreciation—it may upset investor behavior. A quick look at the history of capital gains tax increases can provide some clues.
Capital gains tax rates were increased in 1969, 1976, 1987, and 2013. According to FactSet data,⁴ the average return for the S&P 500 Index three months before the tax increase was 1.4%, and in the 12 months after was 4.3%. The returns were varied and often depended on other factors that were driving the economy and markets. We outline the dynamics in the 2013 example. The increase in the tax rate was from 15.0% to 23.8% and started January 1, 2013. In the fall of 2012, investors in aggregate sold out of U.S. equity mutual funds and exchange-traded funds, but then came back in droves in 2013. Investors who sold before the 2013 capital gains rate tax rate change would’ve missed the best calendar year return for the S&P 500 Index since 2009 at 32.4%.
Funds flowed out before tax increase, then flowed back in
Source: Morningstar Direct, 4/25/21.
In our view, it’s important to focus on bottom-up fundamentals not political developments. Our highest cross-asset conviction call remains U.S. mid-cap equities right now. They’re seeing improving relative strength as the earnings and economic backdrop remains favorable. As for fixed income, the stalling increase of U.S. Treasury yields over the last month may have been the bond market sniffing out higher tax rates in general in 2022. We continue to like corporate bonds, targeting about five years of duration across a fixed-income portfolio. The middle of the credit spectrum is where we’re seeing the best risk/return trade-off with lower quality investment-grade BBBs and higher quality high-yield BBs yielding around 3%.
1 cnn.com, 3/18/21, updated 4/23/21. 2 FactSet, 5/14/21. 3 John Hancock Investment Management, 5/18/21. 4 FactSet, John Hancock Investment Management, 5/18/21.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.