What the Coming Tax Cuts Mean for the Stock Market

Key Points

  • The United States isn't the only country considering corporate tax cuts; the leaders of most major countries are implementing or calling for them.
  • If the global trend of corporate tax cuts leads to a further decline of 10 percentage points, it could imply about a 5% boost to earnings.
  • The impact of tax cuts on earnings is not enough to make it the primary driver of stock prices, but is enough of a potential boost to earnings to help support stock valuations.

The United States isn't the only country considering corporate tax cuts. In fact, the leaders of most major countries are implementing or calling for them. This may be welcome news for stock market investors since it could mean a boost to after-tax profits.

Global trend

In recent years, corporate tax rates have been falling in major countries around the world, as you can see in the table below. More cuts may be coming—especially from those countries that have not recently made cuts to their corporate tax rates.

Corporate tax rates have been falling in many major countries

Corporate tax rates have been falling in many major countries

Source: Charles Schwab, KPMG data as of 4/26/2017.

The U.S. statutory corporate income tax rate is approximately 40%. While the marginal federal corporate income tax rate on the highest income bracket of corporations is 35%, state and local governments also impose income taxes averaging approximately 7.5%. Since corporations may deduct its state and local income tax expense when computing its federal taxable income, this generally results in a net effective rate of approximately 40%.Corporate tax rate displayed is the combination of federal and local taxes and surcharges in each country to allow for accurate comparisons across borders.

  • France – The leading candidate in France’s presidential election, Emmanuel Macron has proposed to cut corporate taxes gradually to 25% from 33.3%.
  • Germany – While leaders in Germany have been staunchly in favor of fiscal discipline and opposed to tax cuts in the recent past, this stance seems to be softening. German Finance Minister Wolfgang Schauble indicated that Germany has room to cut corporate tax rates in a Wall Street Journal interview earlier this year.  Chancellor Angela Merkel's ruling coalition is considering an election campaign pledge to cut corporate taxes in the coming years. Martin Schulz, Merkel's main competitor ahead of September's general election in Germany, is also calling for lower taxes.
  • Japan - Japan was notorious for having the highest corporate tax rate in the world, but that has been rapidly changing. Additional cuts are already set in place for the years ahead. The Tax Reform Act of 2016, enacted in Japan on March 29, 2016, further lowers the corporate tax rate (including the local business tax) gradually to just below 30% (29.74%) in 2018.
  • United Kingdom - The British government, under new Prime Minister Teresa May, has pledged to reduce corporate rates to 17% by 2020 from the current 20%.
  • United States – Unveiled last week, the proposal by President Trump to lower the federal statutory corporate tax rate from 35% to 15% would place the U.S. tax rate among the lowest globally. The House Republican proposal of 20% is less drastic, but still would bring the combined federal and state/local U.S. corporate tax rate down to about 25%, the global average among developed countries.

There are likely to be differences between rate proposals and what may actually emerge as new tax policy. But there is little doubt that the trend continues toward lower tax rates for corporations.

Bottom line

Tax cuts flow straight to the bottom line for companies. Keep in mind that companies pay a lower effective tax rate (which varies considerably) than the statutory tax rate, so the impact of any reduction in the statutory tax rate on after-tax profits is not one-to-one.

Based on the developed market companies that make up the MSCI World Index, a reduction in the corporate statutory tax rate of 1% (assuming no offsetting revenue raising provisions) may lift after-tax profits by approximately half of that amount, or 0.5%. So, if the global trend of corporate tax cuts leads to a further decline of 10 percentage points, it could imply about a 5% boost to earnings. That alone is not enough to make it the primary driver of stock prices, but the prospect of tax cuts is enough of a potential boost to earnings to help support stock valuations.

While we still favor the healthcare and technology sectors, they may not benefit as much from potential corporate tax cuts as other sectors. The sectors that may benefit the most are those that pay the highest effective tax rates (such as the utilities and telecom services sectors), whereas the healthcare and technology sectors tend to pay the lowest effective tax rates, due  to their high percentages of global sales and research expenses.

Drawbacks

There is a potential drawback to the brighter profit outlook from tax cuts: wider government budget deficits, at least in the short-term. This may limit the size of tax rate cuts that actually emerge from lawmakers. At this time, bond markets don’t seem too concerned about a possible return to rising deficits, as government bond yields still remain near all-time lows.

Europe has significantly narrowed its budget deficit to near the best levels seen in decades though years of fiscal austerity combined with rebounding GDP growth, as you can see in the chart below. This steady improvement may explain why the potential for tax cuts doesn't seem to be worrying the markets much right now.

Europe’s budget deficit approaching best levels in 20 years

Eurozone Budget Deficit as a percent of GDP

Source: Charles Schwab, Bloomberg data from Eurostat as of 4/25/2017.

World markets are hitting new highs as world leaders propose corporate tax cuts. Although this is unlikely to be the sole driver, it may make a positive contribution while the revival in earnings growth continues to lift stock prices.

 

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