What history tells us about taxes and the stock market

With his first 100 days as president now officially in the books, we’re starting to see Joe Biden leave his mark on the U.S. political agenda.

On one hand, with a nod to the obstacles he faces in the Senate, Biden has turned to a record number of executive orders to influence directive. These include targeted measures on climate change and actions to control the pandemic. In addition, the Biden administration has leveraged its political backing into stimulus measures aimed at boosting the economy, creating jobs and helping Americans return to work. These include:

• The $1.9 trillion American Rescue Plan Act of 2021. The relief package was signed into law in March and included direct payments to most Americans and an extension of increased unemployment benefits.
• A proposed $2 trillion targeted at infrastructure improvements.
• A proposed $1.8 trillion for family related programs such as child care, education and paid leave.

Of course, these increased spending measures lead to the inevitable question of how they will be funded. To this end, the Biden administration has proposed several tax increases. Notable items include:

• An increase in the corporate income tax rate to 28 percent.
• Specific measures to target multinational corporations, specifically those with a lot of intellectual property in foreign countries. These measures are expected to most heavily impact the technology and health care sectors, as well as the likes of Facebook and Google in the communication sector.

Amidst ongoing political jockeying, we still don’t know what the final word will be. Tax increases seem fairly likely, though not guaranteed. The Democratic majority is razor-thin in the Senate and not exactly huge in the House of Representatives. As such, some of the proposed tax increases are likely to be watered down.

Taxes and the markets

With this lingering tax uncertainty, it’s easy to see how a potential increase in corporate taxes–and subsequent reduction in the share of earnings available to shareholders–could be a negative development for the stock market. Yet, the complexities of financial markets make it difficult to draw such linear conclusions.

For context, we can look at the reaction of stocks to instances of tax increases in the past. As outlined below, U.S. equity markets have exhibited an ability to remain resilient through all but one of the 13 instances of tax increases since 1950.

Equity returns in years with tax increases

S&P 500

Source: Macrobond, RBC GAM. Data as of Dec. 31, 2020. S&P 500 TR Index (USD). An investment cannot be made directly into an index. The graph does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results.

Key takeaways:

• These results do not suggest markets prefer tax increases. Rather, they indicate that markets have historically been able to look past tax increases because of other factors at play. These include elements such as economic growth, government stimulus, support from central banks, and investor sentiment.
• Likewise, in the current environment, the proposed increase in corporate taxes could be a potential headwind on profits. However, with vaccinations progressing and economic activity ramping up, tax increases could prove to be relatively minor compared to the massive gains in expected profits.

We recognize that valuations in pockets of the U.S. equity market are demanding. Undoubtedly, strong profit growth will be required to support these prices. However, for those concerned that a potential increase in corporate taxes will be the straw that breaks the camel’s back, history provides a compelling counter-argument. Rather than focusing on any one policy item, it’s important for investors to have a plan in place that they can stick with in the long run. Taxes et al.