Joe Biden may have promised that “nothing will fundamentally change” if he’s elected, but the Trump tax cuts will be revisited after November in the event of Democratic gains.
This isn’t just a political issue anymore. Just ask Gary Cohn, the architect of Trump’s tax overhaul.
“[Congress] needs to look at our budget — how we spend money — and in addition to that, I think they need to look at our tax system and they have to think of ways we raise revenue”, Cohn told Fareed Zakaria late last month. “You know, if you think back to 1935 and the Depression, some major tax reform came out of that”.
Prior to the COVID panic, one of the biggest concerns for investors was the potential for changes to tax policy. Once Biden locked up the Democratic nomination, some of the angst abated (i.e., “Bernie risk” went away), but nevertheless, it’s still a risk for equity prices.
About a month ago, while discussing indeterminacy around 2021 earnings, I conjured a series of hypotheticals, using Goldman’s projections, consensus forecasts and the bank’s previous outlook for S&P 500 EPS in the event the tax cuts are rolled back. I’ve updated the visual to account for the S&P’s gains since then, and also for a slight revision to consensus bottom-up forecasts for 2021.
Think of Goldman’s downside (as it stood on May 15) as incorporating myriad wild cards around the virus. If you subtract the bank’s projected earnings hit from a hypothetical rollback of the Trump tax cuts from that downside scenario for 2021 EPS (i.e., in order to generate a kind of “absolute worst-case“), you end up with a forward multiple of more than 33.
In a new note, the bank’s David Kostin talks a bit more about this.
“The [S&P] stands just 8% below its February peak. With markets looking ahead to the post-pandemic recovery, investor conversations have increasingly focused on the political landscape”, he writes, noting that prediction markets “now show roughly 50% likelihoods of Democrats winning the presidency and the Senate in November”.
Not surprisingly, Goldman’s clients “see the most important equity market implication” of a prospective Democratic victory as “the potential for higher corporate tax rates”.
Kostin writes that “in some ways, tax policy represents a larger risk to earnings and consequently to equity prices” than the pandemic.
Of course, that depends on how you think about the virus (e.g., its likely evolution, the potential for durable changes in consumer behavior, etc.), but Goldman notes that thanks to policy support (both fiscal and monetary), “investors have largely looked through the coronavirus as a temporary hit to total corporate earnings”.
A change in corporate tax policy, on the other hand, “would reduce expectations for the entire long-term stream of profits”, Kostin says, in the course of reminding you that “every company in the world is in a joint venture” with the government as a partner “and its stake represented by the effective corporate tax rate”.
You can think of the Trump tax cuts as lifting S&P 500 companies’ stake in this joint venture by 10% (to more than 80% from 70%).
“From a valuation perspective, the NPV of the incremental future earnings reallocated by the reduced tax rate suddenly inured to the shareholders whereas it previously benefitted the government”, Kostin goes on to say, elaborating on the point. “That is what happens when the JV split goes from 70/30 to 80/20, but the split may change in 2021 depending on the outcome of the November election”.
To be sure, this matters – a lot. Over the past three decades, half of the increase in corporate profit margins and a quarter of total S&P 500 earnings growth is attributable to falling effective tax rates.
Goldman quickly recaps Biden’s tax proposal as follows:
Presumptive Democratic nominee and former Vice President Joe Biden has proposed partially reversing the 2017 TCJA. According to the Tax Foundation the former Vice President’s plan would raise the statutory federal tax rate on domestic income from 21% to 28%, reversing half of the cut from 35% to 21% instituted by the TCJA. In addition, the plan would double the GILTI tax rate on certain foreign income, impose a minimum tax rate of 15%, and add an additional payroll tax on high earners. These changes would be complemented by a variety of changes to the personal tax code, including an increase in the tax rate applied to capital gains and dividends for the highest income individuals, as well as potential changes in non-tax regulatory policy that could also affect corporate earnings and equity valuations.
If implemented, this would shave $20 from the bank’s 2021 EPS estimate for corporate America.
Goldman writes that although Biden’s plan would only negate around half of the Trump tax cuts in terms of the statutory rate, when you consider it with “other proposals”, it would push the effective rate for S&P 500 companies to 26%. Throw in a presumed “drag on US GDP of a similar magnitude” and you end up with a 12% hit to next year’s earnings.
Of course, you could argue that it’s not the end of the world if corporate America has to pay higher taxes, but shareholders aren’t enamored with the idea, especially at a time when the outlook for corporate profits is still clouded by uncertainty around COVID-19.
Goldman’s Kostin writes that “investors not only face uncertainty regarding the specifics of potential tax reform, but also five more months of market volatility before the resolution of a close political race that could eliminate the likelihood of tax reform altogether”.
I’m not entirely sure that latter bit is accurate. As Cohn emphasized last month, Congress will need to at least consider whether somebody, somewhere, needs to pay higher taxes considering the spending attached to trillions in virus relief.
It’s probably fair to say that most Americans have by now come around to the reality that the Trump tax cuts disproportionately benefited corporations and the wealthy, which means any effort to collect more revenue cannot possibly come in the form of higher taxes for lower- and middle-income earners, especially not at a time when unemployment is high and the economy is still trying to recover from the biggest shock in a century.
Trump has repeatedly promised to do something specifically for the middle-class in terms of tax relief. That promise remains unfulfilled.