The upcoming U.S. election could eventually result in a change in corporate taxes if Joe Biden is elected President and Democrats become the majority party in the Senate, as well as maintaining their leadership position in the House. We have spent the past several months studying the potential impact of Joe Biden’s announced tax plans on our portfolio companies, as well as the broader impact across the major sectors of the U.S. economy.
The following analysis includes the estimated impact of raising the corporate tax rate to 28%, a 15% minimum tax on book profits, and a minimum tax on foreign earnings of 21% which is provided as a scenario to show impact of higher foreign taxes. The universe that we analyzed was the S&P 500 companies ex Real Estate and Utilities.
Key details of the Biden Tax proposals are not available, and the foregoing assumptions are based on Joe Biden’s commentary, his campaign’s tax proposals and analysis from The Tax Foundation and Tax Policy Center. Of course, all these assumptions are subject to change.
To summarize, impacts will vary widely among various economic sectors, but overall median effective tax rates could increase 5%, from 19% to 24% across all sectors, and median earnings could fall by 7%. We are utilizing median values as the data shows wide dispersion even among peers within the same sector with several outliers that would skew average results within these sector groups.
We also found that investor taxes (Capital Gains and Dividends) could also rise under a Biden Administration and result in an unfavorable impact on the investor discount rate, which is near all-time lows in our present zero interest rate environment.
Since the valuation of a security has future earnings in the numerator and an investor’s discount rate in the denominator, the 7% drop in the numerator earnings could be compounded by a rising discount rate in the denominator due to higher effective tax rates among investors.
Trump Tax Cut vs the Biden Plan:
First, what follows is a comparison between the Tax Cut & Jobs Act of 2017 (Trump’s TCJA) and the Biden Tax Plan.
As mentioned previously, many important details of the Joe Biden tax plan are not known at this point which makes the comparison between the two tax positions somewhat ambiguous in certain areas. Additionally, some areas of comparison contain both positive and negative effects which makes it extremely difficult the know the net effect. For example, Joe Biden’s tax plan would encourage U.S. investment (exactly how needs to be more clearly defined), but companies would face severe restrictions with respect to changing their corporate domicile to a more tax-friendly country (offshoring tax penalty). You may remember that these off-shoring restrictions were put in place by the Obama Administration, eliminated by the Trump Administration, and made mostly moot by the passage of the TCJA legislation lowering corporate taxes to 21%. Now, attempting to become a corporate ex-pat under Joe Biden’s tax plan would come with penalties that would make the move a non-starter and reduce corporate flexibility to reduce corporate taxes as a result.
Changing corporate taxes is complex, takes time, and requires a willing Administration & Congress. At this time during the last election, we had a more detailed tax proposal from the Trump campaign (e.g. The Ryan Blueprint). However, key elements of that plan (e.g. the border tax, cutting capital gains) were never passed. It took President Trump and a Republican Congress one year in office to draft and pass the TCJA. In other words, even if we assume a Biden presidency and Congressional support for tax change, we have a long way to go from Biden talking points to full blown legislation and quantifying the actual impacts.
With that said, a change in the U.S. President & Senate will increase the odds of corporate tax change. This will have to be weighed against the possibility of stalling an economic recovery via higher taxes. Given these tradeoffs, one outcome could be a targeted change in the tax code such as a minimum/windfall tax on book profits. However, what seems like a simple statement such as a “15% minimum tax on book profits” often turns into 100’s of pages of legislation and interpretation. For example, companies are still trying to figure out the Global Intangible Low Tax Income (GILTI) tax passed in 2017, which was only recently finalized by the U.S. Treasury and IRS.
All numbers shown in this presentation are preliminary estimates that can and likely will change once we get more detail.
Summary of the Key Changes and Our Tax Assumptions:
- Increasing the Corporate Tax Rate to 28%
– One of the largest revenue raisers in the Biden Tax plan.
– In our analysis, we simply translated U.S. federal taxes from current 21% to proposed 28%.
– Main Impact: U.S. domestics, but an overall tax reform package would likely include offsets to help protect the recovering U.S. economy, possibly minimizing the impact on domestics.
- Minimum Tax on Book Profit (MTB) at 15%
– A key feature of the Biden Tax Proposals to ensure that differences between book and taxable income caused by temporary (e.g. accelerated depreciation) and permanent differences (e.g. stock-based compensation) are taxed at a minimum rate (15%).
– In our analysis, we assume this tax would apply to total pre-tax earnings (adjusted for foreign taxes paid) and be structured as an alternative minimum tax impacting cash taxes, but generally not book taxes.
– Main Impact: Information Technology, Communication Services, and Energy would have large exposure to higher cash taxes under this change.
- True Minimum Tax on ALL Foreign Earnings (e.g. GILTI: Global Intangible Low Taxed Income)
– The original GILTI legislation passed by the Trump Administration and Congress is a minimum tax on an adjusted amount of foreign (based) earnings of U.S. companies. The highest (potential) effective tax rate on GILTI is ~10.5% through 2025 and 13.125% thereafter.
– Joe Biden proposals call for a doubling of this tax to cover ALL foreign earnings on a country by country basis. Because details and company disclosures are limited, our analysis assumes an across the board increase in tax on all foreign earnings (consolidated basis) to 21% (a worst-case scenario).
– Main Impact: U.S. Multinationals, Information Technology and Health Care sectors
Estimated Impact of Biden Tax Proposal by Sector
U.S. domestics would be hit hardest by the Biden proposal by the increase of the corporate tax rate to 28%. Health Care and Information Technology sectors would be hit by increases in higher taxes on foreign earnings (e.g. Global Intangible Low Taxed Income – GILTI).
The graph above depicts the impact on the Effective Tax Rate across the major sectors of the economy. As mentioned earlier, the All Sectors median will increase from approximately 19% to 24%. Energy with its 100% domestic revenue exposure will continue to see the highest Effective Tax Rates. The Information Technology and Health Care sectors have large differences in book and taxable income due to temporary differences between accelerated depreciation and immediate R&D Expensing applied to taxable income vs straight-line depreciation and R&D capitalization for book purposes and permanent differences due to a relatively higher reliance on stock-based compensation which permanently reduces taxable income vs book income. The Minimum Tax on Book Income (MTB) results in these two sectors suffering the largest increases in their Effective Tax Rates.
While all sectors will be adversely affected by higher taxes, the Materials and Energy sectors will see the smallest marginal impact to their Median Impact on Earnings.
Who Will Have the Most Exposure to Potential Tax Increases?
The Potential Impact of Biden Tax Reform on the Stock Market
In addition to raising corporate taxes, Joe Biden has also proposed increasing capital gains and dividend taxes for high earners to ordinary income tax rates (39.6%). Higher investor taxes are generally not good news for the investor’s discount rate, which is currently at historic lows aiding higher stock prices currently. Under Biden proposals, long-term capital gains and qualified dividends would be taxed as ordinary at 39.6% on income > $1million and would eliminate the step-up in basis of unrealized capital gains upon the death of the owner. In general, higher investor taxes can lead to a higher discount rate and potential lower stock prices. Our discount rate is a real, after (investor) tax required rate of return and accounts for these changes.
In the valuation metric pictured below, the price of a security is its present value of future cash flows that accrue to the benefit of the owner. The valuation metric has these cash flows in the numerator (1) divided by the denominator (2) which is the investor’s discount rate (investor’s required rate of return) equaling today’s stock price (3). Under Joe Biden’s tax plan, the numerator (1) will decrease, and the denominator will increase (2) which should result in a lower stock price (3). Of course, not all investors are taxable investors and retirement accounts (e.g. IRAs) and tax-exempt organizations (e.g. pension plans, charitable organizations) will not see an increase in their discount rate due to higher taxes. Accordingly, the overall effect of higher taxes on discount rates will be somewhat muted by the overall tax status of investors.
Finally, with respect to investor’s discount rates the combination of the Federal Reserve’s zero interest rate policy and relatively low tax rates on dividend and long-term capital gain income has resulted in the lowest investor discount rates since, at least, 1960. Joe Biden’s tax plans would increase investor’s taxes back to the levels last seen during the Bill Clinton era in Washington.
Red vs Blue Presidential Election Tracker
The latest Red vs Blue Presidential Portfolio tracker show a dramatic improvement in the Blue portfolio stocks that would benefit from a Democratic sweep of the Presidency and Congress. This recent performance is in line with the average of various presidential polls that see Joe Biden opening a double-digit lead.
John P. Swift, CFA®, CPA
Chief Investment Officer