The recent $2.3 trillion Coronavirus Aid, Relief and Economic Security (CARES) Act effectively tripled the federal budget deficit and ballooned the national debt by nearly 60 percent. In order to reduce the deficit and pay down that debt, the government must raise revenue. Only two options are available to accomplish this. If the economy doesn’t grow at robust pace, Congress could make changes to the tax code. Any changes in tax policy will likely impact stock prices.
Government Estimates for Economic Growth
The Congressional Budget Office (CBO) estimates that between 2021 and 2030, gross domestic product in the United States will grow at an average rate of approximately 2.4 percent, only slightly lower than the 2.64 percent average since 1980.
If history is any guide, then such economic growth ought to be sufficient for long-term equity investors to enjoy comfortable returns. Since 1980, the S&P 500 has had a compound annual growth rate of roughly 8.87 percent.
But what if the CBO’s estimates are wrong? What if the current recession persists into 2021? With unemployment hovering around 11 percent, a robust recovery may not materialize as quickly as analysts predict. If that happens, changes to the tax code may be necessary.
Possible Tax Policy Changes
There are a number of ways that Congress can manipulate the tax code to generate revenue for the treasury.
Changes can be made to:
- Marginal income tax rates
- Taxes on dividends
- Capital gains rates
- Corporate tax rates
- Corporate tax credits
Not all of these solutions, however, would have the same impact on stock prices.
Marginal Tax Rate
Changes to the marginal tax rate are not likely to have a major impact on stock prices because they don’t happen in a vacuum.
Before they go into effect, they are debated in the House and Senate. They then must be signed into law by the president. All of this takes time, and throughout the process, the market effectively and efficiently factors every nuance into stock prices.
Taxes on Dividends & Capital Gains
Taking into consideration investor behavior and past experience, individual tax-rates changes don’t appear to affect stock prices.
Investors seeking a combination of growth and income are not likely to forfeit the potential earnings from high-yielding dividend stocks simply because the tax rate on that income may change. Some may defer dividend income until retirement years, when their marginal tax rate is lower, but completely avoiding such stocks is unlikely.
An increase in the capital gains rate may have a positive impact on stock prices. This is because taxes are levied on profits only when they are realized. An increase in value is not the trigger for the IRS. So, investors holding large unrealized capital gains may be more likely to hold if the tax rate increases.
Historically, there hasn’t been any correlation between the direction of rate changes and stock prices.
In 1981, capital gains rates went from 28 percent to 20 percent. The market declined 22 percent the next year. In 1987, the rate reverted to 28 percent and the market advanced slightly — despite the preceding August crash. Historical data also show instances of stocks moving in the same direction as the change in the rate.
Corporate Tax Rates & Stocks Prices
A change in corporate tax rates is more likely than personal income tax changes to impact stock prices.
Because corporate taxes are a business expense that affects a company’s earnings per share, higher corporate income taxes can translate to lower profits.
Although changes in corporate tax rates are announced and priced into the market well in advance of becoming law, the reality is that investors still compare earnings in absolute terms to the prior year’s number.
Thus, shareholders disappointed by a company’s financial results are likely to sell their stock, causing stock prices to fall.
Eliminating Corporate Tax Credits Could Raise Billions
Businesses have just a few opportunities to claim credits against taxes owed. The most significant among them is the credit for increasing research and development (R&D) investments. Data from the Internal Revenue Service show that between 1990 and 2013, corporations in the United States received nearly $147 billion in R&D tax credits.
Eliminating the R&D tax credit could raise an equal or greater amount for the federal government. Yet the credit is responsible for much of the country’s technological innovation and jobs growth since 1990. So, while eliminating corporate tax credits could raise revenue, the cost to society in lost jobs and payroll tax revenue could potentially outweigh the short-term benefit.
Tax Policy Affects the Economy & Investments
Tax policy changes can target individual taxpayers, corporate taxpayers or both.
Changes in personal income tax rates alter consumer behavior. Tax cuts increase people’s disposable income, which in turn, spurs spending. On the other hand, tax increases can have the opposite effect.
Likewise, corporate tax cuts can encourage businesses to hire and invest more, whereas increases discourage these actions.
Changes in tax policy do, indeed, change consumption and investment. As a result, they can also influence stock prices — positively and negatively.
According to the Tax Policy Center, changes in tax rates can have a substantial impact when the economy is weak, as it is currently. However, such effects are typically short-term. Tax policy changes that increase deficits, however, can slow the economy in the long run.
The correlation between the stock market — which anticipates consumer spending, inflation, interest rates and employment — and the economy is obvious. There seems to be a weaker correlation between stock prices and changes in tax policy.
Mitigating Risk Caused by Taxes Law Changes
Whatever happens to the U.S. economy between now and the end of 2021 will influence lawmakers’ views on taxes. Major changes to the tax code might impact the stock market. Only time will tell.
Investors would be well advised to review their portfolios to affirm that their risk exposure is within their comfort zone — especially if they are at or near retirement age. If your goal is to reduce risk and create guaranteed retirement income, you may want to explore the option of adding an annuity to your portfolio.