The Taxman Is Coming. But Stocks Will Worry About That Later

For now, the obsession du jour is still inflation soup. The recipe is a secret. As Dan Tarullo put it, “we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking.”

But there are plenty of people who suspect they know what’s in the soup. And almost everyone insists the unbridled issuance/creation of money without offsets (i.e., without borrowing or taxing to “pay for it”) is inflationary. “How could it not be?,” they wonder, loudly.

Politicians and most economists generally agree with some version of that, while ostensible market “luminaries” take it as a given. Hence massive Treasury issuance to “fund” today’s stimulus and plans for higher taxes to “pay for” a forthcoming Joe Biden infrastructure proposal.

Read more: New Year’s Resolutions, Infrastructure And Drunken Darts

Taxes will invariably be the market’s next obsession du jour. On Goldman’s estimates, the administration’s infrastructure plan would come with a price tag as high as $4 trillion if it includes money for healthcare, education, and a child care initiative. The bank is looking for “at least” $2 trillion.

What does that mean for taxes and asset prices, where “assets” just means stocks?

We “can’t know what we don’t know,” to use the tautology. But we can make some educated guesses based on what little is known. Goldman reminds folks that Biden proposed lifting the statutory corporate tax rate on domestic income from 21% to 28%, which would, in part, reverse the Trump tax cuts. In addition, Biden would likely lift the rate on foreign income and set a minimum tax rate for corporates.

The bank’s estimates see the Biden tax plan reducing 2022 S&P 500 EPS by about 9% (figure below).

But that’s not the bank’s base case. “Our economists believe Congress will pass a smaller increase,” David Kostin said, noting that Goldman’s current 2022 $197 EPS estimate “assumes the statutory rate rises to 25%, representing a 3% drag on earnings.” Anything beyond that “or the passage of other proposals like the GILTI tax hike” are thus “downside risks” to the bank’s assumptions.

Obviously, any kind of scheme to “phase in” the tax hikes would distribute the actual earnings ramifications across multiple years, but markets being the “highly efficient” (and those are my scare quotes, employed for humor in this case) beasts that they are, the hit would likely be priced in “as soon as the full impact becomes clear,” Goldman suggested.

Are markets priced for this at all currently? Well, are they priced for anything these days other than the assumption that reopening and vaccination goes as planned? Probably not.

“After trading closely with prediction market odds during the months ahead of the general election in November 2020, a pair of tax baskets containing the biggest winners and losers from the 2017 tax cuts has reversed and now appears to be pricing little risk of higher tax rates,” Kostin went on to remark, noting that “screens of stocks facing potential risk from proposals like the GILTI tax hike have broadly performed in line with industry peers in recent months.”

You don’t need an annotation (or even a labeled x-axis ) on the figure (above) to know when the Trump tax cuts were passed.

What’s obvious from the visual is that markets, despite their reputation for “pulling forward” future outcomes, were reluctant to price tax policy until it was a done deal. That’s likely the case ahead of prospective Biden tax hikes as well.

“In the second half of 2017, while legislation was being negotiated and drafted, our tax baskets barely reflected the potential for tax reform,” Goldman’s Kostin wrote late Friday. “It was only a month before the bill’s eventual passage that investors reacted.”

In what I’d characterize as a testament to the notion that American politics is somewhat farcical (Goldman doesn’t say that), Kostin also noted that “a repeated pattern of corporate tax reversals each time political control of Washington, D.C., changes hands should also reduce the degree to which investors price the long-term earnings impact of each new tax legislation.”

And, coming full circle, Goldman said that as a practical matter, “the market’s current focus on other macro issues like interest rates also makes it hard to justify trading on uncertain potential future tax hikes.”

You may be tired of the market’s inflation/bond tantrum obsession du jour. But as another new week dawns, it’s still scrawled in chalk on the specials board right behind the hostess stand when you walk in the front door.