President Joe Biden has unveiled an infrastructure plan that will spend around $ 2 trillion over the next 10 years and plans to pay for it in corporate tax increases – around $ 2 trillion over the next 15 years. The plan is to increase the corporate tax rate from its current 21% to 28%, which is still below the 35% before the 2017 Tax Reduction and Employment Act.
While there are other plausible sources of income, these are likely to be needed for other spending priorities set out in the bill. We therefore believe that it is very likely that Congress this year will collect the taxes on companies that will take effect in 2022. We have set out why we I think this is very likely in a previous article.
Our probability weighted estimate is a new corporate tax rate of 26%. As shown in the graphic below, this estimate includes an 80% probability that a tax increase will even be passed. When a raise is successful, we see an 80% chance that it will succeed at Biden’s suggested rate of 28% versus a 20% chance that it is capped at 25%.
– Source: Morningstar.
In addition, Biden has proposed a substantial increase in taxes on foreign income for U.S. corporations, including changes to global taxes on low-tax intangible income (GILTI) as well as an abolition of foreign intangible income deduction (FDII). We expect these measures to generate at least as much federal income as the increase in the statutory corporate tax rate. However, there is still great uncertainty as to how the details will affect this part of the bill.
Tax changes are likely to have a mid-single digit impact on the average equity valuation
How will the likely tax changes affect US stock valuations? We outline different scenarios for the impact on our average US covered equity using an optimized form of the discounted cash flow models used by our equity analysts.
First, we note that effective tax rates are key to determining the change in stock valuations. Keep in mind that at the time the 2017 tax cuts were passed, the average effective tax rate for S&P 500 companies was down about half the statutory tax rate: 1,400 basis points in the statutory tax rate versus 700 basis points in the effective tax rate. This difference is due to the fact that U.S. corporations’ overseas income is not subject to U.S. tax rates (although the law included some measures aimed at that overseas income, such as the GILTI tax).
We would expect similar effects from this tax change, meaning that the effective tax rate would increase about half as much as the statutory tax rate. A 700 basis point increase in the statutory tax rate (corresponding to the corporate tax rate scenario of 28%) should therefore result in an effective tax rate increase of 350 basis points, and our probability weighted increase of 500 basis points should result in about an effective rate increase of 250 basis points.
With these factors in mind, we designed the following scenarios:
- Scenario A: Here and in Scenario B, the change in the effective tax rate corresponds to the change in the statutory tax rate multiplied by the company’s US revenue share (around 50% on average). That, combined with our probability-weighted forecast of a 500 basis point legal rate hike, will result in a 2.7% decline in average US equity valuations.
- Scenario B: The other possible change in the statutory rate, an increase of 700 basis points, results in a 3.8% decrease in valuations.
However, Scenarios A and B do not take into account the aggressive changes in foreign income taxation that are part of the new tax plan (including GILTI and FDII). While the details of these foreign income tax changes are yet to be determined and are fairly uncertain, in scenarios C and D we attempt a rough analysis.
Here we assume that the change in the effective tax rate is equal to the change in the statutory tax rate (as opposed to scenarios A and B, where it is half the change). This doubling of the effects of scenarios A and B makes sense, as the foreign income tax regulations are expected to generate about as much revenue as the statutory tax increases alone.
- Scenario C: A statutory and effective increase in the tax rate of 500 basis points results in a decrease in average US stock valuations by a total of 5.6%.
- Scenario D: An increase of 700 basis points results in a decrease of 7.8%.
– Source: Morningstar.
Higher government spending will not offset the negative effects of corporate tax cuts
Some investors may wonder whether the negative impact of higher corporate taxes will only be offset by increased spending on the infrastructure package and other proposals. Overall, however, we believe that higher spending is unlikely to be able to offset it, although there will be relative winners and losers across all sectors.
The reason there is no overall compensation for higher spending is because we don’t see any impact of the new spending on US real GDP (beyond the very short term). Therefore, unless spending increases pre-tax corporate profits as a percentage of GDP (we have no reason to believe that it will), no compensation will occur.
Our view that US real GDP will not be affected by higher spending is again based on the views we expressed in a previous article: “Why More Boost Can Only Do So So Much for the US Economy”. Even if infrastructure spending (minus the impact of tax increases) acts as a net fiscal stimulus, a stimulus is only effective to sustainably stimulate the economy when GDP is below its potential level, which means the economy is still weak. We already believe that the U.S. economy could pick up potential by the end of 2022 or so, as labor markets get pretty tight by then.
It may seem counterintuitive that the proposed $ 2 trillion infrastructure spending cannot provide aggregate compensation for the impact of the tax increases, but this is inevitable given our assumptions above.
If GDP is already at its potential level, higher federal investment spending simply means lower spending in other sectors of the economy. This could be due to lower consumption as shareholders respond to the wealth created by the corporate tax hike. State and local governments can reduce their own infrastructure spending as their needs are met by higher federal spending. And ultimately, higher federal spending would increase the equilibrium interest rate slightly and result in lower private investment and consumption.