U.S. Tax Hike: Market Impact on S&P 500

Introduction

The U.S. presidential race is in full swing. Investors are concerned as candidates make uncomfortable economic pledges, including significant corporate tax or tariff increases. Regardless of the election outcome, it appears unlikely that one party will sweep the presidency and both houses of congress, suggesting that dramatic policy changes could face constraints. However, investors should still consider the potential impact of these policies on the economy and stock market and prepare accordingly. This post will explore the potential impact of substantial corporate tax increases on the stock market.

Unexpected Findings

If the corporate tax rate increases substantially, corporate profits will decrease, leading to a decline in stock prices. To offset the decrease in profits caused by the increased corporate tax, companies will likely pursue greater operational efficiency, which could lead to job losses and negatively impact consumption. Decreased consumption will further reduce corporate profits. This sounds logical.

However, according to an article of The Motley Fool (published on 29 September 2024), there have been five instances of corporate tax increases in the U.S. since 1950 and the S&P 500 has risen in all five cases. Hence, it suggests that investors shouldn't worry too much about the prospect of a corporate tax hike (although the article expresses concerns about the current high valuations of the U.S. stock markets.) The specific data mentioned in the article is as follows:

- 1950 tax hike: S&P 500 increased by 22%

- 1951 tax hike: S&P 500 increased by 16%

- 1952 tax hike: S&P 500 increased by 12%

- 1968 tax hike: S&P 500 increased by 8%

- 1993 tax hike: S&P 500 increased by 7%

The Motley Fool cited Fidelity data as the source for these numbers.

Corporate Tax Increases and S&P 500 Returns

Let’s look at the original analysis created by Fidelity.

Source: Fidelity

If you look at the bottom three lines of the chart, you can see that it checks not only corporate taxes but also personal income taxes and capital gains taxes. Since 1950, there have been 13 instances where one or more of these taxes have been increased and 5 instances where corporate tax rates have been increased.

Since 1950, the stock market has always risen in years when the U.S. raised corporate tax rates. Why did the stock market react positively? Because when taxes are raised, there may be a net increase in liquidity in the overall economy due to expansionary fiscal policies that spend more than the additional taxes collected. The comments in the box on the chart also mention that when taxes were raised, spending on social welfare policies or defense was significantly increased. The government can also increase spending on infrastructure such as roads, ports, power plants, and other public facilities.

So, in conclusion, (1) in the past 75 years, the S&P 500 has risen 100% of the time when corporate taxes were raised, and (2) even logically speaking, even if corporate taxes are raised, the economy will rather improve due to increased government spending, so there's nothing to worry about. So, investors don’t have to worry about the potential tax increase at all?

Tax Hikes Are Not All the Same

Let’s check how much the corporate tax rate was raised in the five previous cases.

Source: taxfoundation.org; edited by Neo

• The corporate tax rates in the table are the top marginal rates.
• 1946, 1965, 1988, and 2017 saw no changes in tax rates but were included for comparison with the following year's increased rates.
• 2025 is based on the Democratic Party's pledges and is not a confirmed future.

Of the five instances since 1950 when the U.S. raised corporate tax rates, the period from 1950 to 1952 is particularly noteworthy as it represents three consecutive years of increases. The rate was raised from 38% to 52%, a cumulative increase of 14 percentage points. This was due to the need to raise taxes as U.S. national debt reached nearly 120% of GDP in 1946 in the aftermath of World War II. (For reference, U.S. national debt as a percentage of GDP was 122.3% at the end of the second quarter of 2024, which is slightly higher than in 1946 but very similar.)

The 1950s and 1960s were the period of greatest prosperity in U.S. history. During this time, average annual GDP growth rate was 4.2% in the 1950s and 4.5% in the 1960s. Since then, there has been no decade with average annual growth of 3.3% or more. It was the best of times, with rapid economic growth, low unemployment, and (until the late 1960s) low inflation. It's difficult to compare that era to the present. Additionally, while 1950, 1951, and 1952 are different years, they are consecutive years and had better be considered as a single case from a political and economic perspective.

Let's look at the other two cases. In 1968, despite the tax increase, the S&P 500 rose by 8%, but fell 11% in the following year. While the stock market typically does well at anticipating future cash flows, that's not always the case. Although it is believed that the primary reason for the stock market crash in 1969 was the Federal Reserve's interest rate hikes in response to inflation exceeding 5%, the 1968 tax increase may have also played a role.

Finally, let's look at the 1993 case. While there was a corporate tax increase, it was only from 34% to 35%, a mere 1% increase. In other words, for a corporation paying $100 million in taxes, assuming all else being equal, it would have to pay an additional $2.9 million. Let's compare this to what’s currently proposed. The corporate tax rate would increase from the current 21% to 28%, a 7 percentage point increase. In other words, a corporation paying $100 million in taxes would have to pay an additional $33.3 million. This is not comparable to 1993. Even the 1968 corporate tax increase, at 5.6% in terms of percentage, was quite far from  what's currently proposed.

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Closing Remarks

If the federal government reinvests the excess tax revenue generated from tax increases back into the economy through fiscal policy, it could stimulate economic growth. However, it's well-known that the private sector typically allocates capital more efficiently - a fundamental principle of a market economy.

Investors don’t need to worry too much about the promised corporate tax hike yet, as a divided Congress and presidency are likely to limit its implementation. However, if the tax rate were raised as proposed, we shouldn’t assume the S&P 500 would respond as positively as it did in the past five instances. A closer look at those precedents may lead you to agree.

Thanks for reading. Wish you grow rich slowly and surely!

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