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President Biden’s budget calls for higher corporate taxes and it is only a matter of time before it becomes law.
Melina Mara-Pool / Getty Images
April 15th is still over seven months away, but it’s time to think about taxes.
Not income tax, mind you, but changes to corporate tax law that may emerge from the budget vote process that is only now beginning in Congress. President Biden’s budget calls for higher corporate taxes and it is only a matter of time before it becomes law thanks to a narrow Senate Democratic majority. Even West Virginia Senator Joe Manchin, a moderate Democrat, appears to be on board as long as the incentives that would support the higher levies are paid. And that means taxes have to go up. The corporate tax rate could rise from 21% to 25%, partially reversing some of President Donald Trump’s tax cuts.
The market doesn’t seem too concerned about this – or much else – right now. Sometimes it responds to news of the spread of Covid-19 and its variants, or the possibility of tighter monetary policy, but even then the volatility was short-lived. Investors seem pleased for the most part as stocks climb to record highs.
But tax hikes are likely, whether investors are ready or not, as Democrats have little choice. Mid-term elections will take place in 2022, and with images of the botched exit from Afghanistan and falling approval from Biden, the party knows that “failure is not a realistic option,” says Brian Gardner, chief Washington strategist at Stifel Nicolaus. He estimates the likelihood of both the roughly $ 1 trillion infrastructure bill and the $ 3.5 trillion budget vote being passed at about 10%. But that jumps to 65%, he claims, if the household bill is reduced to $ 2-3 trillion and the tax levy diluted a bit. “The Democrats need a victory on these laws, and they will likely pass both after reducing the size and volume of the $ 3.5 trillion bill,” predicts Gardner.
Don’t expect stocks to turn down a tax hike. Bank of America strategist Ohsung Kwon estimates that a corporate interest rate of 25% would lower earnings estimates by 5% for 2022, potentially wiping out all expected earnings growth for the next year. The technology and health sectors would be the hardest hit, falling 7%, while energy, real estate and utilities would remain largely unscathed. That applies no matter how many incentives are included in the prospect, says Kwon: “Even if higher taxes are combined with an infrastructure bill, the profit will be more direct and immediate, while the benefits of the infrastructure are spread over time.”
This is worrying given that revenues – particularly profit estimates – are the
S&P 500
higher. However, the market hasn’t even started considering the potential impact. Wolfe Research strategist Chris Senyek created two baskets of stocks – one that would be most affected by tax increases and one that would be least affected. He looked at not only the potential increase in the corporate tax rate, but other tax changes, including the increase in the tax on foreign subsidiaries of US companies, known as GILTI. He paired match with match so that the basket wasn’t distorted by sector bets.
The basket of stocks with low tax sensitivity includes, for example
Canadian National Railway
(CNI), with no dependency on US tax rates, while the more tax-sensitive basket includes:
CSX
(CSX), a US railroad company. In the tech sector, this is based in the Netherlands
NXP Semiconductors
(NXPI) is paired with the US tax sensitive
Intel
(INTC). See Senyek
MC Donalds
(MCD) as less tax sensitive than
Dominoes
(DPZ), and
Twitter
(TWTR) less than
Netflix
(NFLX).
When the market thought of taxes, the tax-insensitive basket should overtake the tax-sensitive basket. Instead, the most tax-sensitive stocks gained 25% through Aug. 30 that year, while the least tax-sensitive stocks rose around 22%, a sign that investors need to factor even higher taxes into their calculations for individual stocks, Senyek says. That makes a strange sense. At Washington, you never know what will happen until it does. “Investors are always skeptical about political changes,” observes Senyek.
In 2017, stocks didn’t start pricing the effects of Trump’s Tax Cuts and Jobs Act until about six weeks before it was signed on December 20. Don’t be surprised if the market reacts the same this time around – in reverse.
Write to Ben Levisohn at [email protected]