Market Commentary: Higher Taxes?

While market volatility has recently ticked up due to inflationary concerns, another cloud looms on the horizon: taxes. Much of the funding for President Biden’s $2 trillion infrastructure proposal revolves around increasing taxes on corporations and households making over $400,000/year. 

The fear is that raising taxes, especially coming out of a pandemic, will stall the economy and, in turn, hurt the stock market. While this sounds worrisome, history has shown that markets have actually outperformed in periods where tax rates increased. As we often emphasize, markets are complex and influenced by multiple factors. Fixating on one does not provide the whole story.

Type of Taxes

Taxes can be broken down into three main components:

• Personal

• Corporate

• Capital gains

Since 1950, there have been 13 years where at least one of the three increased. 

Source: Haver/FMR.

The stock market’s reaction to those increases has been pretty remarkable:

• The S&P 500 yielded a positive return in 12 of the 13 years.

• In the five years where two tax types increased, the S&P 500 averaged a ~21.2% annual return.

• In the two years (1968 and 1993) where all three increased, the S&P 500 returned 8% and 7%, respectively.

• The S&P 500 yielded a positive return 100% of the time in the year prior and during the year when corporate taxes increased.

The assumption that higher taxes will slow economic growth and drag markets lower seems not to hold true. Markets have, in fact, excelled under these conditions. Does this mean that higher taxes have no impact on the economy and markets? No, but history shows this fear is often overblown and should be taken into context with other factors in the global economy.

Of course, things feel different today, as we haven’t faced anything near the level of a pandemic since the 1950s. We’ve also never had such an accommodative Congress and Federal Reserve, which have unleashed trillions of dollars into the financial system. While the outcome of this experiment will be felt over the coming years, it’s something to be mindful of now.

The big question is why do markets seem to excel during periods of tax increases.

Tax Reform

The reality is change takes time, especially tax reform. Changing the U.S. tax code is extremely complex, and legislation can take years to see the light of day. A majority of proposals are “dead on arrival,” but this does stop some from speculating with their investments. In the end, what passes typically ends up being less than what was proposed and leads to a market rally as the “worst case” scenario is avoided.

Much of the funding for President Biden’s infrastructure bill would come from increasing the U.S. corporate tax rate from 21% to 28%. This would mark the first increase since 1993 and only the sixth hike since 1945. This proposal has led many to forecast a dire earnings picture for corporate America, typically a negative for the stock market. 

The data paint a different picture. During the last five corporate tax rate increases, the S&P 500 posted average annual returns of 12.9%. As impressive as this is, it’s even more so when compared with the 4.6% average annual return during the nine periods when corporate tax rates decreased!

Corporations are nimble and can adapt to economic changes, whether on the tax front or elsewhere. If tax increases were analyzed in a vacuum, one would conclude that higher corporate tax rates are better for the stock market. 

Yet it’s important to remember that taxes are one of the many factors that shape an economy. It should also be noted that significant tax reform has occurred only a handful of times over the past 70 years, confirming just how difficult it is to get such legislation passed.

Will President Biden’s proposal go as planned, or will it end up like most pieces of tax legislation, somewhere in the middle? Time will tell …

Discuss your situation with a fee-only financial advisor.

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