How corporate tax hike will affect US equities
The Biden administration's infrastructure plan could mean a mid-single-digit impact on the average equity valuation, write Preston Caldwell and Aron Szapiro.
US President Joe Biden has unveiled a US$2 trillion ($2.56 trillion) infrastructure plan that he plans to pay for largely with increases in corporate taxes. We believe the Democrats are highly committed to passing the plan, and both procedural and political reasons dictate that the bill be roughly deficit-neutral.
Moreover, there are few other sources of revenue outside of those the president outlined to pay for the package. In short, we believe there is a high probability that Congress will raise taxes on corporations this year, effective in 2022.
Our probability-weighted estimate is a new corporate business tax rate of 26 per cent, up from the current 21 per cent. Furthermore, higher taxes on corporations' foreign income are very likely, though details on this front are more uncertain.
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Scenario A (Exhibit 1) shows the simulated impact to our average US equity valuation if the corporate statutory rate increases by our probability-weighted expectation of 500 basis points. If we assume that the increased foreign income taxes pack the same punch as the increased statutory rate (which seems likely, as the two are projected to raise similar amounts of revenue), that yields Scenario C.
All in all, this suggests a mid-single-digit impact to the average equity valuation. While some investors are wondering whether this negative impact can be offset by the massive increase in infrastructure spending, we think there will be no offset in aggregate, as our long-run GDP outlook is essentially unchanged by the new spending.
Tax changes likely to deliver mid-single-digit impact to average equity valuations
Expect corporate tax rate to rise from 21pc to 26pc
Biden has unveiled an infrastructure plan to spend around US$2 trillion over the next 10 years and plans to pay for it with corporate tax increases that will raise around US$2 trillion over the next 15 years. While there are other plausible sources of revenue, these will likely be needed for other spending priorities, so we believe there is a high probability that Congress will raise taxes on corporations this year, effective in 2022.
Biden's proposal is to increase the corporate tax rate to 28 per cent from the current 21 per cent (but below the 35 per cent before the Tax Cuts and Jobs Act of 2017). Our probability-weighted estimate is a new corporate business tax rate of 26 per cent (Exhibit 2a), which incorporates an 80 per cent probability that any tax increase is passed at all (Exhibit 2b). Conditional on an increase passing, we've pencilled in an 80 per cent probability that Biden's proposed 28 per cent is passed versus a 20 per cent probability that the increase is limited to 25 per cent.
Additionally, Biden has proposed large increases in taxes on US corporations' foreign income, including changes to global intangible low-taxed income, or GILTI, taxes, as well as a repeal of the foreign-derived intangible income deduction, or FDII. We expect these measures to generate at least as much federal revenue as the increase in the statutory corporate tax rate. However, there's still a lot of uncertainty as to how the details for this part of the bill will play out.
Our probability-weighted expectation is an increase in the corporate tax rate to 26pc from 21pc
Our equity analysts will be incorporating the anticipated probability-weighted change to the statutory rate over the next quarter into their models and fair value estimates. For the changes in taxes on foreign income, we're holding off on major changes until more clarity is given on the new measures.
Tax changes set to fall almost entirely on shareholders
Our analysis above assumes that the burden of tax hikes falls entirely on shareholders. While this may sound straightforward, economic theory suggests this isn't necessarily the case. Once the economy adjusts to the tax changes by finding a new equilibrium, the burden of the tax may be shared with consumers, labour, and noncorporate owners of capital.
This occurs via an increase in corporations' pretax returns on capital, which partially offsets the hit from the tax increase. For example, in economist Arnold Harberger's classic paper, the burden is split proportionally by all owners of capital.
Impact of corporate tax statutory rate increase across sectors driven by US exposure
Modern empirical research hasn't answered the question of who pays for the corporate tax, but the Urban-Brookings Tax Policy Centre assumes that about 70 per cent of the long-run tax is paid for by shareholders. We think it could be even higher than this, and combined with the fact that the adjustment process could take many years, we think it's fair to assume that shareholders bear the vast majority of the burden of the tax hikes.