Inflation Reduction Act: Could It Hit Stocks?

Of all the policy changes included in the recently passed 2022 Inflation Reduction Act (IRA), two likely stood out for investors: the 1% excise tax on stock buybacks and the new 15% corporate minimum tax.

It seems reasonable to assume that taxes like this could pose risks to the economy and stock market, and the projected tax receipts from these two measures are substantial enough. Congress' Joint Committee on Taxation estimates these levies could raise nearly $300 billion over the next decade.

However, changes in tax policy don't often work out how you'd expect. Underlying macro (and micro) forces generally have more influence on the trajectory of growth and stock prices. We believe that while these two taxes could hit certain parts of the market harder than others, the overall risks are small. Here's why.

The tax on stock buybacks is slated to take effect next year. Companies that repurchase shares from shareholders will pay a 1% levy based on the net amount of shares the company buys (in other words, the total number of shares repurchased minus the number of shares issued during the year). Why was this provision added to the bill? Critics have long suggested that buybacks encourage short-term thinking by diverting capital from more productive investments and juicing share prices at the expense of long-term value.

Aside from the arguments for or against buybacks, our view is that this new tax is unlikely to upset the market as a whole but could change behavior among the more acquisitive sectors—potentially by adding more fuel to this year's surge.

Buybacks have surged in recent years. The rolling four-quarter sum of buybacks among S&P 500^® Index companies hit nearly $1 trillion in the first quarter of 2022.

However large this number may seem, though, it's not extreme by historical standards. In terms of the value of buybacks relative to the size of the market, the most recent reading of 0.7% is roughly half the 1.2% peak in 2007. Not only that, but each new wave of buybacks since 2007 has peaked at a lower level than the wave that preceded it.

In other words, the recent surge doesn't necessarily indicate a market broadly addicted to its own shares.

At the same time, certain sectors have been more enthusiastic buyers of stock than others. From the first quarter of 2021 through the first quarter of 2022, the Information Technology ($275 billion worth), Financials ($210 billion worth), and Communication Services ($140 billion worth) sectors led the way, accounting for nearly two thirds of all buybacks during the period.¹

In theory, that could mean these three sectors face the biggest risk from the new tax—that is, if their performance were determined solely by the value of their buyback activity. Of course, that's not the case.

For one thing, each sector tends to be keyed into different parts of the economic cycle. Financials can (but don't always) benefit from rising interest rates and tend to perform better when the economy is entering or in the middle of a growth phase. The Tech sector, on the other hand, can struggle when interest rates are rising, because higher rates tend to dent the appeal of the potential future cashflows from which tech companies derive so much of their value.

Even during bear markets, performance doesn't always rhyme. During the sharp (but short) pandemic-triggered bear market from February-March 2020, Financials fell by 43% while Tech fell 31%. For the first six months of the bear market in 2022, Financials fell by 12% while Tech fell by 21%.²

If anything, the main short-term effect from this new tax could be companies deciding to pull forward their buyback plans in the hope of completing them before the tax kicks in next year. Ironically, the final result could be both an acceleration of the pandemic-era rise in buybacks and a continuation of the broader secular decline in buyback activity.

The corporate minimum tax will also take effect next year. It works like this: Companies with more than $1 billion in annual profits over a three-year period will have to apply a 15% rate to their book income, which is the income they report to shareholders and doesn't include deductions or tax credits. If that amount is higher than their tax liability without those items, they'll owe the higher amount. (That makes it a little like the Alternative Minimum Tax for individuals.) The goal with this provision is to capture more tax revenues from companies that might otherwise avoid some (or all) of their liabilities.

One thing to note before getting into the specifics of the new tax is that even with it, the corporate tax burden is extremely low by historical standards. As a percentage of pretax profits, federal corporate tax receipts have trended lower over the last seven decades—from nearly 50% to just under 10%. There have been periods of medium-term increases—such as the early 1980s and early 2000s—but the secular downtrend remains intact.

And, again, looking solely at corporate tax rates without reference to broader economic conditions will provide a limited view of the market. Considering them all together reveals a perhaps not-that-surprising dynamic: When times are good, tax receipts rise with the market. When times are bad, tax receipts grow more volatile.

Sometimes the financial and economic tides are too strong to resist. The aftermath of the Tax Cuts and Jobs Act of 2017, which lowered the corporate tax rate from a maximum 35% to 21%, is a case in point. If tax rates alone were destiny, we might have expected an immediate surge in stock returns. Instead, 2018 was marred by several events that caused intense market drawdowns: the implosion of the short volatility trade in February (resulting in a 10% correction in the S&P 500 in just nine days); the start of a manufacturing recession; the start of a Federal Reserve rate-hiking cycle; and the start of a trade war. At its worst point, the S&P 500 was down 19.7%—just shy of the 20% line indicating a bear market—and talk of a recession became common.

Where does that leave us with the present day's legislation? As with the tax on buybacks, the effects are more likely to fall on select parts of the market than to weigh on the market more broadly. If we screen for firms in the S&P 500 that make more than $1 billion in pre-tax adjusted profits and had an effective tax rate of less than 15% as of the last reported year, nearly 100 firms fit the bill.

Firms from certain sectors—such as REITs, Industrials, and Energy—have a bigger average gap between their recent effective tax rates and the new 15% floor. But that average masks the fact that a few players within these sectors are responsible for most of the shortfall, as you can see in the chart below.

Whether we're talking about buybacks or tax rates, the reality is that if there are risks from this new legislation, they are likely to be concentrated within a few sectors and/or companies. And some of those companies could be strong enough financially not to be bothered either way.

At this point in the economic cycle, it's much more important for investors to consider the macroeconomic conditions that are weighing on the market. With the Federal Reserve fighting inflation, demand slowing, economic growth contracting, and sentiment souring, the market was already facing stronger headwinds before the Inflation Reduction Act came on the scene.