Tax hikes are the next big investor worry

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Tuesday, March 23, 2021

Higher corporate taxes could take a 9% bite out of S&P earnings

As we wrote in The Morning Brief on Monday, investors can always count on some big worry hanging over the market.

And in an environment in which it seems everything happens faster, it should come as no surprise that as soon as consensus fears shifted from a double-dip recession to higher inflation, another fear has come along. And that fear is higher taxes.

Bloomberg's Nancy Cook reported Monday that the Biden administration is "determined" to increase taxes after passing a $1.9 trillion COVID-19 relief package less than two months after taking power. And the New York Times reported Monday that the Biden administration is targeting $3 trillion worth of spending, potentially over multiple pieces of legislation targeting infrastructure, clean energy, and universal pre-K among other measures.

And while the details of any proposals to offset include higher taxes are far from settled, Wall Street analysts are already exploring what the impacts of a higher corporate tax rate could have on earnings. And at the high end, this hit could amount to nearly 10% of corporate profits in 2022.

"Our economists expect the next [fiscal] package will be paid for in part by higher tax rates, including on corporate earnings," said Goldman Sachs' equity strategy team led by David Kostin.

"The tax plan proposed by President Biden in his election campaign would raise the statutory corporate tax rate on domestic income from 21% to 28%, partially reversing the cut from a rate of 35% passed in the 2017 Tax Cuts and Jobs Act. The plan would also raise the tax rate on foreign income (also called the “GILTI” tax) and institute a minimum corporate tax rate.

"We estimate the Biden tax plan would reduce 2022 S&P 500 EPS by about 9%. However, our economists believe Congress will pass a smaller increase. Our current $197 EPS estimate assumes the statutory rate rises to 25%, representing a 3% drag on earnings. A hike to a rate above 25% or the passage of other proposals like the GILTI tax hike would represent downside risk to our estimate."

Unlike fears of higher rates or faster-than-forecast economic growth, the market isn't yet pricing in any potential negative impacts to profits from a return to 2016 corporate tax levels.

"In the second half of 2017, while legislation was being negotiated and drafted, our tax baskets barely reflected the potential for tax reform," Goldman writes. "It was only a month before the bill’s eventual passage that investors reacted."

On a sector level, Communication Services (XLC) and Technology (XLK) are the two sectors most likely to see large impacts not only from an increase in the statutory rate but also changes related to how foreign income is taxed. These two sectors are home to FAAMG names which have been major drivers for corporate profits.

Technology and Communication Services, which house the market's biggest companies and profit generators like Apple, Facebook, and Microsoft, are at most risk of seeing earnings hit by an increase in corporate taxes. (Source: Goldman Sachs)

But as Goldman notes, tax policy tends to be a "believe it when I see it" kind of trade for investors. Over the few months, stocks levered to a potential infrastructure bill that might include some tax hikes have outpaced the broader materials sector, suggesting relative optimism around that plan getting through. Stocks exposed to higher taxes, in contrast, have been tracking the broader market, indicating investors have been quiescent about this risk.

As we draw closer to the Biden administration unveiling an outline for this legislation expect to hear more from investors and the analyst community about how higher taxes on businesses — or wealthy individuals, for that matter — could impact financial markets.

But don't expect this news to be more than another market worry until we're right up against the day lawmakers start casting votes.

By Myles Udland, reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland

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