Our expectation is that the final packages on spending and taxation will look different to those proposed.
Global Market Strategist
Since becoming U.S. President, Joe Biden has announced USD 6trillion in fiscal stimulus measures. The USD 1.9trillion American Rescue Plan came back in January and the impacts of its USD 1,400 stimulus checks are currently flowing into the economy. But in subsequent months, there has been the American Jobs Plan (USD 2.3trillion) focused on rebuilding U.S. infrastructure and the more recent American Families Plan (USD 1.8trillion). These are big numbers in both an absolute and relative economic terms and come at a time when politicians and markets are more tolerant of higher levels of debt. However, funding these stimulus packages through higher taxes creates a headwind for U.S. equities.
The plans announced are unlikely to be policies agreed. Democrats generally approved of the measures in the huge American Rescue plan that were paid for by increasing government debt. However, the proposals to fight climate change, build infrastructure, fund education by imposing a higher taxes on companies and wealthier households are unlikely to find the same broad based support.
Given the magnitude of President Biden’s policy agenda and the slim Democratic majority in the House and the Senate, the current proposals will likely be scaled back if they are to make it through the political process. As such, the proposed increase in the corporate tax rate from 21% to 28% may end up being closer to 25%. In addition, the global corporate minimum tax rate, if agreed to internationally, would likely be lower than the current favored rate of 21%. Even if the proposed tax rates are not met, higher taxes will create a drag on earnings. Further, the proposal to raise the capital gains tax for those earning over USD 1million could sharply reduce the after-tax expected return on stocks for very wealthy investors and thus be another negative for the equity market. A politically delicate decision.
The procedure for passing an increase in spending also limits the scope for what may eventually be delivered. The passage of legislation through the Senate requires 60 votes, however, this can be reduced to 51 votes under the Budget Reconciliation process. However, the reconciliation process is budget neutral, which means that over the 10 year budget forecast horizon spending and revenue changes must be equal. A challenge to the corporate tax proposal which expects to pay for 8 years of infrastructure spending over a 15-year timeframe.
Despite all the challenges to both the size and scope of the current spending packages and how they are to be funded, there is still a good chance that changes to tax legislation for both the corporate income tax and the capital gain taxes will be passed in some form before the end of the year.
EXHIBIT 1: S&P 500 earnings per share
INDEX ANNUAL OPERATING EARNINGS
It is not all bad news. The positive impact on economic growth from the infrastructure spending plans and the associated increase in earnings should partially offset any increase in taxes but over mismatched timeframes. The impact of higher taxes on profits will be immediate while the higher growth and earnings benefits will be delivered over a longer time frame. Overall, without a clear indication surrounding the size, scope or timeframe for implementing spending and tax policies, it is hard to imagine that markets are adequately reflecting what an increase in taxes means and presents a challenge to capital markets over the coming year.
Investors are rightfully concerned that tax increases could reduce corporate profits impinging on equity returns in the coming year. Taking into account the various tax proposals and the offsetting impact from the positive effects on economic growth and earnings from the infrastructure spending, it’s estimated the President Biden’s fiscal plan could reduce corporate earnings by 4-5% in 2022. This drag on earnings growth comes at a time when companies are experiencing a robust economic and earnings recovery, which should create some ability to absorb a potential tax increase.
Our expectation is that the final packages on spending and taxation will look different to those proposed. As discussed, the narrow margin to pass legislation as the sheer number of policy changes will be a high hurdle for many in both the Democratic and Republican Party.
The Tax Cuts and Jobs Act signed by former U.S. President Donald Trump in 2017, which reduced individual and corporate tax rates, benefited some more than others. The same will be true of any tax increase and technology, communication services and health care sectors may experience a larger impact as tax loopholes are closed on foreign earnings. In contrast, industrial, energy and materials sectors stand to gain from the spending aimed in increasing America’s infrastructure capacity and green energy network.
Even as U.S. equity markets make new all time highs, there is still potential for positive returns with a lower profile if taxes do increase. The prospects of higher yields driven by the economic recovery, higher taxes and spending on infrastructure should favor those sectors sensitive to the recovery, such as financials, industrials and consumer discretionary that are likely outperformers, but stock selection is becoming increasingly important.