The dog days of summer are an unusual time to be writing about taxes. So, why am I interrupting your summer BBQ or beach holiday with commentary on taxes? Given that the political environment has never felt more divisive than it does right now, I tried to select a topic for this month that has nationwide agreement. Americans hate paying taxes. Sure, some folks take pride in paying their taxes for government services rendered. Sort of a taxes as a necessary evil philosophy. And, of course, there are raging debates about who actually pays or should pay their fair share of taxes and which types of taxes are most tolerable (e.g., income, payroll, capital gains, estate, property, sales, value added tax, corporate, etc.). However, when all is said and done, nobody, and I mean nobody, likes paying taxes.
While taxes are generally a mid-April matter, there are many reasons why taxes should be top-of-mind for investors this summer.
It’s a Smile, It’s a Kiss, It’s a Sip of Wine…It’s Tax Time? On July 4, Americans will celebrate Independence Day. And oppressive taxes, such as the Tea Tax and Stamp Act imposed on the colonists by Great Britain, were a main catalyst for the American Revolution. In some ways, the July 4th holiday is an annual reminder that Americans' extreme dislike of unjust taxes traces its roots all the way back to the birth of our nation.
Also this year, in response to the COVID-19 pandemic, the traditional US tax day of April 15 has been extended three months, to July 15. Therefore, in the next few weeks many Americans will be gathering their tax-prep documents and firing up the TurboTax® Deluxe software to see where they stand with Uncle Sam.
Finally, the US election is just four months away on November 3 -- and both the Democratic and Republican National Conventions are scheduled to be held in late August in Milwaukee and Charlotte, respectively. That means how to pay for the massive fiscal and monetary policy responses to the COVID-19 pandemic will be part of this summer’s political debates.
Some estimates of the US budget deficit now exceed $4 trillion in 2020. Congress has already passed four separate pieces of legislation totaling $2.4 trillion and a fifth stimulus package with a $1.5 trillion price tag is expected to pass this summer. The Federal Reserve has pitched in too, expanding its balance sheet by more than 70% this year to $7 trillion as of June 22. Finally, the US national debt stands at $26.3 trillion, rapidly on its way to an embarrassing $30 trillion burden for future generations.
Source: Peter G. Peterson Foundation. Office of Management and Budget, Historical Tables, Budget of the US Government: Fiscal Year 2021, February 2020; and Congressional Budget Office, The 2019 Long-Term Budget Outlook, June 2019. Note: Mandatory Programs include Social Security, the major federal health programs, and other entitlement programs, and offsetting receipts.
Despite both political parties' apparent eagerness to spend our country’s way to prosperity, not surprisingly, the Democrats’ soon-to-be presidential nominee, Joe Biden, and the Republican incumbent President, Donald Trump, have polar-opposite tax plans.
Neither candidate should underestimate the impact the tax debate could have on the election. A campaign tax blunder likely cost at least one former US president his re-election bid. In accepting his party’s nomination, on his way to the presidency, George H.W. Bush famously said, “Read my lips, no new taxes” at the 1988 Republican National Convention. Four years later, in the 1992 election, President Bush’s broken promise came back to haunt him. He eventually lost his re-election campaign to then national newcomer and rising Democratic star, Bill Clinton.
From my perspective, regardless of your political affiliation, it’s not about if taxes will increase in the future, it’s more a matter of when will they increase, by how much, and who ultimately will pay them.
The Summer Wind Came Blowin’ In
While Independence Day, the extended July 15 tax deadline and the run-up to the election are all likely to ensure that taxes remain a hot topic this summer, investors should be alarmed that the threat of higher future tax rates could depress the outlook for stocks.
According to Empirical Research Partners, all of the margin improvement experienced by S&P 500 companies since 2015 has been attributable to lower tax rates. In fact, stable and/or falling capital gains, dividend, individual and corporate tax rates for much of the last two decades have been an under-appreciated boost to stock prices. This tax tailwind shifting to a headwind could complicate the outlook for future stock returns.
Please, let me be clear. I’m not making a political judgement whether higher tax rates are good or bad. I am simply suggesting that as policymakers attempt to rein in yawning debt and deficits an important tailwind for historical stock returns probably will become less positive. Higher taxes will likely curtail growth and lower returns at some point in the future. In the midst of the COVID-19 pandemic, it is too soon to act on the possible consequences of these probable tax hikes. However, investors probably will have to consider the impact of higher tax rates in the not-too-distant future.
It seems reasonable that a change in US leadership will likely lead to higher corporate and capital gains tax rates as early as 2021. As a result, many investors are grappling with the impact a reversal of the 2018 corporate tax cut would have on profit margins and the stock market. It’s difficult to determine the effects of a rise in corporate tax rates on stocks because it happens so rarely, just twice in the past 80 years. It’s mainly been a global race to the bottom, with India and the US seeing the largest declines in corporate tax rates. By some estimates, a reversal of the 2018 corporate tax rate could reduce S&P 500 earnings by 7-8%. Market multiples would also likely contract because going forward companies will be compounding at a lower level of margins. Empirical Research Partners suggests that the market’s multiple could decline by about half a point. They acknowledge that the reduction could be larger because companies paying low tax rates in the technology and healthcare sectors have gained a greater share of the earnings pie.
In recent years, technology and healthcare have been the market’s leading growth sectors. Coincidentally, they pay the lowest effective tax rates and generate the highest profit margins. Declining taxes have been a key component to their growth equation. Exploding debt and deficits from around the world may result in desperate attempts to increase tax rates on these growth sectors, eventually hurting margins.
Changes to capital gains tax rates occur more frequently, including once in the 2010s, but the impact on markets and multiples is much more difficult to determine. Some research indicates that high beta, high multiple stocks are most negatively impacted by rising capital gains taxes. This also might suggest that some of the high-flyers in recent years would be hurt by an increase in capital gains tax rates.
The bottom line is that rising corporate and capital gains tax rates have the potential to slash growth rates, reduce profit margins and contract multiples for some of the sectors that have led the market in recent years.
Source: Historical Data Sourced from Strategas Research Partners as of January 27, 2020. Current Data Sourced from Factset and Bloomberg as of 6/24/2020.
Those Days Are Gone Forever. I Should Just Let Them Go
The gigantic fiscal and monetary policies in response to the COVID-19 pandemic have built an important bridge from economic recession to recovery. However, the mounting debt and deficits will need to be addressed in the future. And there are no good options. Policymakers will need to raise taxes, slash spending or monetize the debt. Maybe all three. None of these options are particularly good for future economic growth, inflation or stock returns.
Source: CRFB as of 6/24/2020. GDP and Pre-crisis projections are based on data from the Congressional Budget Office's March 2020 budget projections. Post-crisis projections are based on the Congressional Budget Office's April 2020 near-term budget projections and its May 2020 Interim Economic Projections
The probability of a change in US leadership has been climbing in recent months. And with that change, investors may see a shift in corporate and capital gains tax rates. Stable and/or falling tax rates have been a somewhat unnoticed aid to stock returns over the past couple of decades. If taxes increase, investors may need to recalibrate their expectations for future returns, growth rates, profit margins and market multiples -- especially for some of sectors that have led the market in recent years.
Higher tax rates are inevitable, but their impact on future stock returns remains unclear. It just doesn’t feel like it will be very good.
S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
The views expressed in this material are the views of Michael Arone through the period ended June 28, 2020 and are subject to change based on market and other conditions. This document contains certain statements that
may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
Past performance is no guarantee of future results.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s
particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
Standard & Poor's®, S&P® and SPDR® are registered trademarks of Standard & Poor's Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation's financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index.
Distributor: State Street Global Advisors Funds Distributors, LLC, member FINRA , SIPC, an indirect wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., member FINRA, is the distributor for DIA, MDY and SPY, all unit investment trusts. ALPS Portfolio Solutions Distributor, Inc., member FINRA, is the distributor for Select Sector SPDRs. ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc. are not affiliated with State Street Global Advisors Funds Distributors, LLC.
THIS SITE IS INTENDED FOR U.S. INVESTORS ONLY.
No Offer/Local Restrictions
Nothing contained in or on the Site should be construed as a solicitation of an offer to buy or offer, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction. SSGA Intermediary Business offers a number of products and services designed specifically for various categories of investors. Not all products will be available to all investors. The information provided on the Site is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.
All persons and entities accessing the Site do so on their own initiative and are responsible for compliance with applicable local laws and regulations. The Site is not directed to any person in any jurisdiction where the publication or availability of the Site is prohibited, by reason of that person's nationality, residence or otherwise. Persons under these restrictions must not access the Site.
Information for Non-U.S. Investors:
The products and services described on this web site are intended to be made available only to persons in the United States, and the information on this web site is only for such persons. Nothing on this web site shall be considered a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.
Before investing, consider the funds' investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 1-866-787-2257, download a prospectus or summary prospectus now, or talk to your financial advisor. Read it carefully before investing.
Not FDIC Insured * No Bank Guarantee * May Lose Value