April 15 is still more than seven months away, but it’s time to start thinking about taxes.
Not personal income tax, mind you, but changes to the corporate tax code that could emerge from the budget reconciliation process only now beginning in Congress. President Biden’s budget calls for higher taxes on companies, and it’s simply a matter of time before it becomes law, thanks to the Democrats’ slim voting majority in the Senate. Even West Virginia Sen. Joe Manchin, a Democratic moderate, appears to be on board, as long as the stimulus that the higher levies would help fund is paid for. And that means taxes will have to go up. The corporate rate could rise to 25% from 21%, partially undoing some of President Donald Trump’s tax cuts.
The market doesn’t seem all that worried about this—or much else —right now. Sometimes, it reacts to news of the spread of Covid-19 and its variants or the possibility of tighter monetary policy, but even then the volatility has been short-lived. For the most part, investors appear to be quite content as stocks edge up to record highs.
But tax hikes are likely, whether investors are ready or not, because Democrats have little choice. Midterm elections will occur in 2022, and with images of the botched exit from Afghanistan looming and Biden’s approval rating dropping, the party knows that “failure is not a realistic option,” says Brian Gardner, chief Washington policy strategist at Stifel Nicolaus. He puts the odds of both the roughly $1 trillion infrastructure bill and the $3.5 trillion budget reconciliation bill passing at about 10%. But that jumps to 65%, he contends, if the budget bill is reduced to $2 trillion to $3 trillion, and the tax levy is watered down a bit. “Democrats need a win on these bills, and they will likely pass both after reducing the size and scope of the $3.5 trillion bill,” Gardner predicts.
Don’t expect stocks to shrug off a tax increase. Bank of America strategist Ohsung Kwon estimates that a 25% corporate rate would cut 2022 earnings estimates by 5%, potentially erasing all of next year’s expected profit growth. The tech and health-care sectors, with a 7% decline, would take the biggest hit, while energy, real estate, and utilities, for the most part,would be unscathed. That’s true no matter how much stimulus is incorporated into the outlook, Kwon says: “Even if higher taxes are packaged with an infrastructure bill, the hit to earnings will be more direct and immediate, whereas infrastructure benefits will be spread out over time.”
That’s concerning, given that earnings—particularly earnings estimates—have been driving the
higher. The market, however, hasn’t even begun to consider the potential impact. Wolfe Research strategist Chris Senyek created two baskets of stocks—one that would be affected the most by tax hikes and one that would be impacted the least. He considered not only the potential rise in the corporate rate, but other tax changes, including the increase in the tax on U.S. companies’ foreign subsidiaries, known as the GILTI. He paired like with like, so the basket wouldn’t be skewed by sector bets.
For instance, the basket of stocks with little tax sensitivity includes
Canadian National Railway
(CNI), with no exposure to U.S. tax rates, while the more tax-sensitive basket includes
(CSX), a U.S.-based railroad company. In tech, the Netherlands-based
(NXPI) is paired with the more U.S. tax-sensitive
(INTC). Senyek sees
(MCD) as less tax sensitive than
(TWTR) as less so than
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If the market was thinking about taxes, the tax-insensitive basket should be outpacing the tax-sensitive basket. Instead, the most tax-sensitive shares gained 25% this year through Aug. 30, while the least tax-sensitive were up around 22%, a sign that investors have yet to incorporate higher taxes into their calculus on individual stocks, Senyek says. That makes a strange kind of sense. With Washington, you never know what’s going to happen until it happens. “Investors are always skeptical of policy changes,” Senyek observes.
In 2017, stocks didn’t start pricing in the effects of Trump’s Tax Cuts and Jobs Act until about six weeks before it was signed into law that Dec. 20. Don’t be surprised if the market reacts the same way this time—in reverse.
Write to Ben Levisohn at Ben.Levisohn@barrons.com