The surprising truth about corporate tax changes is that historically the markets haven’t reacted to them in the way you might expect. The markets have risen with corporate tax rises, such as in the 1950s. The markets have also been relatively subdued during tax cuts, such as in the early 1980s. The might be the opposite of what you expect. The underlying reason is likely that periods when politicians ponder changes to the tax code (whether up or down) tend to be periods of economic stability, which are generally good for the market. Also, given the complexity of the corporate tax code, simply looking at the top-line tax rate can miss the nuances of changes in loopholes and deductions that can matter at least as much for the markets. By looking at the top-line alone, moves under the surface can be missed.
A Look At History When Taxes Rise
Historically, the S&P 500 has been fairly unresponsive to changes in the corporate tax rate. Let’s take a look at the data. Back in 1949-1952 just after the Second World War the top rate of corporate income tax rose from 38% to 52%. That’s a steep increase in corporate taxes. If corporations are paying more in tax, then that’s less in profits for shareholders. So what happened to the S&P 500? Disaster? Significant declines?
No, over this period the S&P 500 rose just under 70%. Clearly a substantial rise for stocks. That occurred during the largest corporate top line tax rate increase in post-war history. Within that period, 1951 the year of a 9% absolute increase in the corporate tax rate saw a 24% rise in the stock market. Quite the opposite of what you may have expected.
Now, of course, taxes may rise because the economy is strong, and in this case the economy enjoyed a boom after the Second World War, and was coming out of a brief recession. Nonetheless rising taxes don’t appear to hurt the stock market as much as you would have thought. Smaller rises in the headline rate in 1968 and 1993 tell a similar story, tax rates rose and yet so did the broader market. It’s strange to see the market rising as taxes go up.
This is an important reminder that tax changes are only one component of stock market returns, and potentially a small factor at that. In fact, one of the things we can say about changes to the tax code is that historically tax changes have often coincided with periods of relative calm for the economy. Politicians generally aren’t fiddling with the nuances of the tax code during recessions, given other more pressing concerns.
So perhaps the bigger picture here is that the sort of environment that enables politicians to consider longer term topics such as reforms to the tax code, perhaps because of an absence of other immediate concerns, have been good for stocks historically. This is not because of the tax changes themselves, but the sort of year where you can consider changing the tax code, is probably a reasonable year for economic growth, and the stock market tends to care about economic growth above all.
And When Taxes Fall
So what might falling corporate taxes mean for stocks? Well perhaps the best example is Reagan’s tax cuts of 1987 and 1988, these were substantial for the top line. Was this a bonanza for stocks? Here the markets rose by 6% and 16% respectively. So pretty good, but in the same decade, the Economic Recovery Tax Act of 1981, which cut taxes, actually saw the stock market fall slightly for the year. This is no doubt in part because interest rates were rising to around 15% on 10 year Treasury bonds and the markets were understandably concerned about getting inflation under control (for comparison 10 year Treasury bonds yield between 2% and 3% today). So in looking at the major post-war moves in tax we’ve actually seen the markets do better when headline taxes where rising than falling.
Interestingly, these years of top line tax cuts in the 1980s actually represented 3 of the 4 weakest years for the markets for the decade. Again, this is not what we would expect. More broadly in the 1980s, the main theme was in inflation was coming under control, helping stocks, and this narrative dominated any tax issues. However, it’s important to remember that though Reagan cut top line tax rates, the tax changes also attempted to broaden the tax base by closing loopholes and deductions repeatedly in the 1980s and by targeting revenue neutral tax changes, so the presentation of Reagan as cutting taxes may be true of the top line tax rate, certainly the headline rate came down. However, the base for those taxes increased. So, the tax cut wasn’t quite as unambiguous in reducing tax payments as some suggest. It’s possible that the markets absorbed that information faster than writers of headlines and history did.
Effective Tax Rates
There are other caveats when considering tax issues. US corporations tend to pay a much lower rate of tax than the headline tax rate suggests. The headline tax rate is currently 35% (before any state taxes), but various studies of US corporations, including this one from the Government Accountability Office, find that very few actually pay that. The effective tax rate is far lower. The study found a tax rate of 13% (or 17% when state taxes were included). That study was completed in 2010, when losses from the 2008 recession may have been causing larger than normal losses and deductions.
Nonetheless most studies suggest that US corporations are paying much less than 35% on their profits, and generally effective rates of taxation never approach the headline rates, at least in living memory. There’s a reason there are more than a million tax experts in America, this is more than professional fire fighters and law enforcement officers combined. This means that the gains from tax reform may be less impressive too. If corporations aren’t actually paying the top line rate than cutting that rate has less of an impact.
Also, clearly any changes to deductions, credits and other areas of the tax code should be closely watched. Changes here have potentially more impact on the tax that’s actually paid by corporations than headline rates. Of course, given that the tax code approaches 75,000 pages it’s perhaps not surprising that the easier to digest headline rates attract the headlines.