Why a Corporate Tax Hike Wouldn’t Sink S&P 500 Profits and Stocks

The prospect of corporate tax changes has long been a contentious issue in American economics, leading to debates among investors, policymakers, and business leaders. However, recent analyses suggest that a hike in the corporate tax rate would not have as much of a detrimental effect on corporate profits or the stock market as many headlines imply. Particularly, much of the hype stems from the implications of the Tax Cuts and Jobs Act (TCJA) of 2017, which reduced the U.S. corporate tax rate from 35% to 21%. As this legislation is set to expire at the end of 2025, discussions surrounding tax changes are on the rise again, especially with contrasting views from political leaders.

The Tax Landscape for Corporations

A key argument against fears related to tax rate hikes centers around the complex nature of the U.S. tax code. Many investors may not realize that the headline tax rate is only one of many factors that affect a corporation’s tax liabilities. According to a Government Accountability Office (GAO) study, about half of large U.S. corporations do not pay any corporate income tax in an average year. Furthermore, among profitable companies, around 25% also evade corporate taxes.

This discrepancy exists mainly due to a myriad of possible tax credits and deductions that corporations can leverage, which means that profitability—rather than tax rates—plays a much more significant role in determining their tax burdens. Hence, if corporate tax rates were to increase, it is plausible that companies would simply pass these costs onto consumers by raising prices, particularly given the growing pricing power many companies have accumulated.

Pricing Power and Profitability Trends

Over the last several decades, corporations have slowly gained increased pricing power, a theme highlighted by Lawrence Tint, former U.S. CEO of BGI. This trend aligns with the consolidation seen in various industries, where a small number of companies command the majority of the market share. This enhanced pricing power enables these companies to maintain their profit margins relatively unchanged, even amidst fluctuations in tax rates.

A compelling illustration of this pricing power can be seen in the S&P 500’s profit margins. Despite the turbulence triggered by the TCJA and inflationary pressures, profit margins have displayed remarkable consistency. For instance, the profit margin for the S&P 500 was 10.9% in the fourth quarter of 2020, remaining stable amid rising inflation over the following years.

The Limitations of Profit Margin Growth

However, it is essential to recognize that profit margins do operate within certain limits, as noted by Rob Arnott, the founder of Research Affiliates. He warns that history shows profit margins can experience backlash, potentially causing them to plateau or drop after a period of rapid expansion. Arnott also predicts that, after witnessing extraordinary earnings growth over the past decade, corporate profits may see minimal growth in the coming years, regardless of whether tax rates are increased or maintained.

The Future of Corporate Earnings

If profit margins stagnate, corporate earnings are unlikely to outpace sales growth. As previously reported, the S&P 500’s sales per share have historically lagged behind U.S. GDP growth—growing at only 0.6% below the GDP’s annualized percentage. With the Congressional Budget Office forecasting a 1.8% annualized growth rate for GDP over the next decade, a similar trend could dictate corporate earnings growth at just 1.2% annually until 2034.

Final Considerations for Investors

Given the current high valuations of U.S. equities—where the S&P 500’s forward price-to-earnings (P/E) ratio exceeds historical averages—investors may want to temper their expectations for future returns. As Arnott asserts, it is plausible to foresee a scenario where U.S. large-cap equities fail to even keep pace with inflation over the next decade.

In conclusion, while discussions surrounding corporate tax hikes persist, it may be prudent for investors to redirect their focus toward fundamental market dynamics such as corporate profitability, pricing power, and prevailing economic growth trends. Amid fluctuating tax policies, the broader implications for the S&P 500’s profit margins and overall stock performance appear to hinge more significantly on these underlying factors rather than changes to the tax code itself.