Why higher stimulus may outweigh higher taxes

Russ discusses the potential impact of more economic stimulus alongside higher taxes.

For much of late September and October, market gains - particularly for more cyclical companies - suggested investors had made peace with a Democratic sweep. For many, this seemed an odd outcome. While a Democratic sweep would remove the uncertainty and fear of a contested election, and significantly raise the odds of another stimulus package, taxes are almost certain to go higher.

Focusing on corporate taxes, assuming corporate tax rates don’t impact valuations, and there is little evidence that they do, the question comes down to an inequality: Will the increase in stimulus lift top-line growth enough to offset the hit to the bottom line?

My view is that, at least in the near term, stimulus can offset a tax increase. That said, ultimately the answer will depend on a handful of factors: implementation, timing and the magnitude and composition of the stimulus.

Effective tax rate versus the marginal rate? The Biden tax proposal envisions a hike in the corporate tax rate, from 21% to 28%. That much is clear. What is less obvious, particularly when you consider the political sausage making that will precede an actual deal, are the ultimate details of a package. Every industry tends to have a different effective tax rate, i.e. the tax rate after deductions and tax credits. How these more nuanced expressions of the tax code evolve will determine how much more companies really pay.

Timing of a tax hikes. While the U.S. economy has rebounded faster than expected, it remains well below full capacity. Unemployment is still at recession levels and growth is vulnerable to a third wave of the pandemic. Against this backdrop there is a good chance that tax hikes, particularly on the corporate side, will be phased in rather than immediate. This is critical as it will determine when earnings are impacted. The more the hikes are delayed, the smaller the likely drag on stocks.

Size and efficacy of stimulus: If taxes are the drag, the offset will be a stimulus induced acceleration in nominal gross domestic product (NGDP). A reasonable rule of thumb is that a percentage point increase in NGDP translates into roughly the same increase in earnings (see Chart 1). In order to compensate for a seven to eight percentage point drag on earnings from higher taxes, the stimulus bill will probably need to be about $2 trillion. A larger or more efficient package, i.e. one that is particularly well targeted towards lifting NGDP, would allow for potentially faster earnings growth.

Nominal GDP Growth vs. Corporate Profits

Chart: Stimulus Outweigh Taxes

Source: Bloomberg, as of October 28, 2020.

Democratic sweep = continued cyclical rally?

The bottom line for investors is that an early and well targeted stimulus package can, at least in the near-term, lift markets higher. Under this scenario the biggest beneficiaries are likely to be many of the cyclical names and industries that have been outperforming since September. This does not suggest that higher taxes won’t ultimately matter; simply that a large stimulus package may be the key catalyst, at least for now.

Russ Koesterich
Portfolio Manager
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and is a regular contributor to Market Insights.