Studying President Joe Biden’s Tax Policy Proposal and its effect on the Equity Markets
Intending to revive the COVID-19 affected American economy, President Joe Biden and the Democrats on April 7 proposed a new Tax regime to finance their economic stimulus and $2 trillion Infrastructure bills.
The policy effectively negates former President Donald Trump’s 2017 Tax legislation by increasing the effective tax on companies and the rich. The changes also aim to benefit the poor and employed, middle-class Americans by increasing the value and quantity of tax credits they can use to decrease their tax liability.
Government officials argue that this policy will raise $2.5 trillion in tax revenues for 15 years, and the University of Pennsylvania economists appraise the benefit to be higher at $2.1 trillion for 10 years with the increased effective tax on companies contributing half of these revenues.
What are the specifics of this policy and how will it affect investors and their investments?
Increasing the Effective Tax on Companies
The policy aims to increase the Corporate Tax to 28%. However, Republicans and centrist Democrats have stated that they will argue against a 28% Corporate Tax in the US Congress and consequently, economists are presuming that the tax will be increased to 25% instead.
The ‘Global Intangible Low-Taxed Incomes’ or GILTI Tax will increase from 10.5% to 21% (and to 26.5% in 2026), increasing the effective tax on companies’ non-US, international incomes. GILTI is the income earned by the foreign affiliates of US companies from their intangible assets.
To tax corporations that paid zero or negative taxes in the past, the policy will implement an Alternative Minimum Tax of 15% on the book incomes. Book income is the income announced to the companies’ investors and shareholders; however, it is not used in determining the tax liability. AMT will be implemented on companies with yearly incomes of more than $2 billion.
The new regime will also have a provision referred to as ‘Stopping Harmful Inversion and Low-Tax Developments’ (or SHIELD) that will disincentivize companies from incorporating themselves in low-tax nations to decrease their incomes and consequent tax liabilities in the United States.
Presently, the American affiliates of companies incorporated in Ireland (a low-tax nation) can transfer their profits to the Irish company as costs and decrease their taxable income in the United States. SHIELD will proscribe this practice and consequently increase the tax liability of companies in the United States.
Taxing Rich Investors
Investors whose yearly income is more than $1 million will have to pay the same percentage on their investment income as tax, as it applies to normal incomes. Additionally, the ‘carried interest’ provision, used by portfolio administrators to pay the lower Capital Gains Tax instead of normal Income Tax on their incomes, will be annulled.
Effect on Equity Markets
Goldman Sachs economists have appraised that a 28% Corporate Tax will decrease companies’ income by 9% in 2022 whereas a 25% Tax, which has a higher possibility of being ratified in the US Congress according to them, will decrease incomes by 3% in 2022. GILTI and AMT Taxes will add to companies’ tax liability and further decrease their incomes.
According to Goldman Sachs, the incomes of companies in high-growth sectors like technology and telecommunication will be the worst affected, whereas incomes of companies in cyclical sectors like energy will be the least affected.
Though companies’ income will fall because of a rise in their tax liability, economists have stated that this fall will produce an insubstantial negative effect on the companies’ stock price valuations. Regardless, it will be advantageous to invest in stocks of companies (as described in the exhibit) that will be least affected by the implementation of this new regime.
Because the increased tax revenues will be used to finance infrastructural development, the consequent higher economic growth in the US will negate the effect of decreased company incomes. This reiterates the viability of investing in stocks of companies in the cyclical sector.
At the prospect of tax raises after President Barack Obama’s reelection in 2012, multiple companies declared dividends for their investors (though the increases did not materialize). Accordingly, companies might also declare similar dividends for their shareholders as they did in the past and it will be advantageous for investors to hold income stocks.
An increase in investors’ tax liability will not have a noticeable effect on the stock prices, according to economists. In the past, an increase in investors’ tax liability through an increase in the Capital Gains Tax has produced no long-term effect on the stock prices or the equity markets in general as investors’ tax liability and CGT have no relation with stock price valuations. For instance, S&P 500 rose by 30% in 2013 even though CGT was increased by the then administration.
It will be interesting to note how the US Congress reacts to President Joe Biden’s new tax policy proposal and what it will ratify and implement.