The federal "Inflation Reduction Act," signed into law in August, has some investors nervous about a potential impact on the U.S. economy and markets. However, we think the tax changes in the new law will have less of an adverse impact than many investors fear.
Beginning in January, the Inflation Reduction Act (IRA) will impose a new 1% tax on stock buybacks and a 15% corporate minimum tax on certain companies. (Note: There are no tax changes that will directly affect individual taxpayers.) At first glance, this may appear likely to weigh on corporate buybacks and companies' bottom lines. However, it's worth noting that not all stocks will be affected equally: Certain sectors are likely to be harder-hit than others, and even those facing a bigger hit to buybacks or profits may already be in a relatively stronger position to withstand it.
Before we take a deeper look at the changes, we want to emphasize that it's always difficult to tie any legislation directly to economic and market outcomes. Often, the underlying macro (and micro) forces at work are much better explainers of stock prices and/or the trajectory of the economy.
Bye-bye, buybacks?
For stock buybacks, the direct hit to the overall market will likely be minimal. It's important to consider the impact of the law in the context of the current economic and market environment. It's true that the rolling four-quarter sum of S&P 500 buybacks did eclipse $1 trillion in the second quarter of 2022, as shown in the chart below.
Buybacks surged in dollar terms…
Source: Charles Schwab, Bloomberg, as of 6/30/2022.
However, that must be looked at in the context of the market's value over time. As shown in the chart below, while buybacks rose throughout the pandemic, the current reading of 0.7% is nearly half of the 1.3% peak in 2007. Not only that, but each successive peak since 2007 (i.e., in 2011 and 2018) has been smaller in magnitude.
…but are less impressive in terms of market value
Source: Charles Schwab, Bloomberg, as of 6/30/2022.
Implications at the sector level are likely to be varied. Consider that, from the second quarter of 2021 through the second quarter of 2022, the Information Technology, Financials, and Communication Services sectors saw buybacks total $284 billion, $189 billion, and $142 billion, respectively—as shown in the first chart below. As a share of all stock buybacks, that adds up to 61%, as shown in the second chart.
Thus, these three sectors will feel the most acute dollar impact from the tax. Conversely, the Utilities, Real Estate, and Energy sectors—all of which command the smallest share of overall buybacks—are unlikely to experience a significant impact.
Sector impacts vary
Source: Charles Schwab, Bloomberg, as of 6/30/2022.
It's worth pointing out that, even though the Technology and Financials sectors yield the largest shares (respectively) of overall buybacks, there is little guarantee that their performance will be affected in a similar manner. Not only do Technology stocks tend to be reflected in growth indexes while Financials are typically found in value indexes, both sectors often assume leadership at nearly opposite points in the cycle.
At risk of oversimplification, while the Financials sector doesn't always benefit from rising rates, it is more sensitive to the economic cycle—thus typically enjoying stronger performance when the economy is in the early-to-middle-growth phases. At the opposite end of the spectrum, the Tech sector is often at risk of rapidly rising interest rates, given that members' earnings are typically pushed further out into the future and are disproportionately affected by a higher discount rate.
Even within bear markets, performance doesn't always rhyme. In fact, during the sharp-but-short bear market induced by the COVID-19 pandemic in February and March 2020, Financials fell by 43%, while Technology fell by 31%. For the first six months of the bear market in 2022, Financials fell by 12%, while Technology fell by 21%.
For the reasons listed above, we think the ultimate impact of the buyback tax across the market as a whole will be less substantial than some investors fear—if not because of the relatively small percentage of dollars that will be taxes, then certainly because of the small share of sectors (three) that have made up the majority (61%) of total buybacks over the past year. If anything, in the short term, companies may decide to pull forward their buyback plans in hopes of avoiding the tax that kicks in at the start of 2023. Yet that would simply continue the accelerating trend throughout the pandemic, not arrest a secular decline over the past decade in buyback activity.
The tax facts
The IRA also creates a new 15% corporate minimum tax, which would apply to companies with more than $1 billion in annual profits over a three-year period. Before discussing the specific implications of it, we think it's instructive to look at the historical relationship (or lack thereof) between changes in tax policy and market returns. Conventional wisdom might suggest that an increase in tax rates would lead to weaker returns (and vice-versa), but this isn't always the case.
First, it is important to keep in mind that federal tax receipts from companies as a percentage of pretax income has fallen during the past seven decades—from nearly 50% to just under 10%. In other words, the burden has decreased over time. As shown in the chart below, there have been periods of medium-term increases—such as the early 1980s and early 2000s—but the secular downtrend remains intact.
Beast of (smaller) tax burden
Source: Charles Schwab, Bloomberg, as of 6/30/2022.
In terms of tax changes' relationship to the change in the stock market, the trend throughout history has been mixed at different points in economic cycles, but for the most part, both have tended to move up together. The following chart plots the annual change in corporate tax receipts as a percentage of profits vs. the annual change in the S&P 500. For the most part, outside of recessionary periods, both have moved in the same direction—countering the notion that an increase in taxes coincides with weaker market returns.
Moving together, often
Source: Charles Schwab, Bloomberg, as of 6/30/2022. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Another way to look at the relationship over time is to analyze the effect of changes in the capital gains tax rate. As shown in the scatterplot below, between 1968 and 2013 there was virtually no correlation between the change in the S&P 500 index and the capital gains tax rate.
Spotty relationship
Source: Charles Schwab, Bloomberg, Treasury Department. 1968-2013. Maximum tax rate includes effects of exclusions, alternative tax rates, the minimum tax, alternative minimum tax, income tax surcharges, and the 3% floor under itemized deductions. Midyear rate changes occurred in 1978, 1981, 1997, and 2003. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Forward-looking investors might argue that there is a lagged, adverse effect on the market. As shown in the chart below, the relationship strengthens (that is, turns increasingly negative) as the correlation flips to -0.4. However, we would point out that three of the strongest hikes in the capital gains tax rate resulted in double-digit percentage gains for the S&P 500 one year later. Variability should always be considered in instances like these.
Weak negative relationship
Source: Charles Schwab, Bloomberg, Treasury Department. 1968-2013. Maximum tax rate includes effects of exclusions, alternative tax rates, the minimum tax, alternative minimum tax, income tax surcharges, and the 3% floor under itemized deductions. Midyear rate changes occurred in 1978, 1981, 1997, and 2003. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
We will also emphasize a point alluded to at the beginning of this note. More often than not, it is increasingly beneficial to consider present-day macro conditions and their ability—as opposed to specific legislation—to hold more influence over the market. Case in point is the 2017 federal tax cuts. At face value, a substantial cut in the tax rate and attendant boost in fiscal stimulus might suggest that stock prices should benefit.
Yet, the reality is that 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; a Federal Reserve engaging in a rate-hiking cycle; and the launching of a trade war. All helped propel the market into near-bear-market territory (the S&P 500 fell by 19.7% at its worst point) and raised recessionary fears to a considerable degree. As such, the fiscal boost was overshadowed by deteriorating market and economic tides that were too strong to reverse.
Haircuts of different lengths
Moving onto the present day's legislation, the potential tax impacts likely will vary across sectors. As mentioned earlier, the minimum 15% tax will apply to companies with at least $1 billion in profits during a three-year period—essentially limiting the pool to large-cap companies. In screening for companies in the S&P 500 that made more than $1 billion in pre-tax adjusted profits in the last reported year, and had an effective tax rate of less than 15% as of the last reported year, nearly 100 companies fit the bill.
As shown in the chart below, some sectors—such as Real Estate, Industrials, and Energy—face a steeper tax rate shortfall. Others, like Materials and Consumer Discretionary, will have to come up with a smaller additional amount. However, note that even though the Industrials sector faces a large gap, the share of companies that may have to make up for the adjustment is small, both in absolute and relative terms. That contrasts with a sector like Health Care, in which there is a less extreme shortfall but larger percentage of companies that may have to pay up.
Who owes what?
Source: Charles Schwab, Bloomberg, as of 7/31/2022. Tax rate shortfall is the spread between 15% and the average effective tax rate for each sector. Companies facing tax rate shortfall are those with at least $1 billion in pre-tax adjusted income, and have had an effective tax rate of less than 15% in the last reported year.
If anything, the segments of the market that stand to face the most pressure from the increase in the tax rate are those that are growth-dominated—namely, Information Technology and Health Care. Yet, while they command a larger share (combined), the shortfall percentage isn't as steep relative to cyclical sectors like Energy and Industrials. For those reasons—along with the fact that Technology in particular has some of the strongest profit margins among sectors—the impact on the market and overall earnings may be smaller than feared.
In sum
On the surface, the IRA may appear to be harmful to companies' bottom lines, but we think that presumption masks several differences underneath the surface at the sector level. Whether analyses are centered around buybacks or tax rates, the reality is that certain sectors are likely to face larger hits than others, and even those facing larger reductions in buybacks or profits may already be in a relatively stronger position to withstand the hit.
Aside from the smaller-than-feared impact to profitability, we think that, 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 still fighting a 40-year high in inflation by aggressively raising interest rates (along with quantitative tightening), demand slowing, gross domestic product off its peak, and sentiment at dour levels, we think headwinds for the market remain strong—not to mention that they were in place well before the IRA was assembled and passed.
As such, we encourage investors to stick to disciplines of diversification and rebalancing—incorporating them within financial plans that take risk tolerance and time horizon into consideration. Now is not the time to take undue risk, and we continue to emphasize that investors seek out high-quality segments of the stock market—namely, those with strong balance sheets, positive earnings revisions, and healthy profit margins.