Kenneth H. from Albany, NY asks: Good Morning Mitch, I would like to hear your thoughts on the tax proposals associated with the infrastructure bill. Do you think higher corporate taxes will affect corporate earnings, and therefore the markets?
Mitch’s Response:
Thanks for writing, Kenneth. The first thing I’d like to note is that the recently announced $2.3 trillion infrastructure proposal is just that – a proposal. I think it is important for investors to remember that it is not advisable, in my view, to make portfolio adjustments based on tax increases that may happen. I think the best practice is to respond to what politicians do, not what they say.
That being said, the initial proposal laid out by the Biden administration seeks to raise the corporate tax rate from the current 21% up to 28%. A key takeaway here is that the conversation for corporate taxes is now centering around 28%, versus the previous 35% level. This is an important takeaway – prior to the 2017 Tax Cut and Jobs Act, the corporate tax rate hovered above 30% for well over 50 years, so resetting the tax conversation down to 28% is important here.1
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As for corporate earnings and the markets, raising corporate taxes up to 28% will almost certainly impact earnings, but I’m not sure the impact will be as large as most skeptics think.
I think we’d see a reduction in after-tax corporate return on invested capital (ROIC) by less than 1%, and we would also see a slight move lower on the U.S. equity earnings yield – maybe moving it closer to the rate on risk-free Treasuries. This may spur some volatility, but I do not see a good reason why U.S. corporations would stop delivering accelerating earnings over time.
At the end of the day, I am not saying raising taxes is a good thing for earnings and profits. But marginal shifts in the tax rate are also not powerful enough to make or break a business cycle, in my view. Here’s an analogy to consider: if an umpire declares in the 7th inning that home runs no longer count as runs, the competing teams will adjust their game plans and score runs in other ways. Businesses do the same with changes to the tax code, and the business cycle carries on. Remember, too, that one of the best growth decades in U.S. history (the 1990s) happened with the corporate tax rate at 35%. Innovative, profit-seeking businesses find a way.
In my view, taxes alone may not be powerful enough to drive long-term market performance. The stock market is affected by too many other factors: interest rates, corporate earnings, inflation, economic growth, expected profits, and so on. Taxes matter, of course, but marginal changes to the tax code have not stifled economic growth and/or pulled stocks permanently lower in the process.
Even still, the bill is very far from becoming law, and even moderate Democrats have reservations. I think it is important at this stage to watch the evolution of the bill closely before making too many assumptions about what will become law. As we have seen many times in the past, there is plenty of political posturing and ‘negotiating’ that will need to happen in the coming weeks and months before we see any clarity on what actually may become law.
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Disclosure