How Biden’s Corporate Tax Hike Threatens Stocks

Here’s an investing problem worth looking at.

Corporate profitability for the companies in the S&P 500 are now at a stratospheric level; in the 98% percentile going all the way back to 1975, according to a recent report from Wall Street powerhouse Goldman Sachs

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But at the same time, proposed increases in corporate tax rates could put the breaks on profits growth. That should concern investors in the SPDR S&P 500 exchange-traded fund, which tracks the S&P 500.

First, corporate return on equity (ROE) over the recent 12 month period, a key measure of corporate profitability, jumped 4.8 percentage points to 19.6% at the end of the second quarter, the Goldman report says. That increase was almost solely driven by an increase in profit margins, the analysis shows. Higher ROE is usually associated with higher stock returns over the long-term and vice versa.

The information technology , consumer discretionary, and financial sectors did particularly well over the recent four quarter period.

Corporate Tax Mess 2022?

That’s good as far as it goes. What matters now is the future and that’s where thing start to look less rosy.

“We expect the outlook for ROE will become more challenging in 2022,” the Goldman report says. “Tax hikes represent the largest potential headwind to ROE growth in 2022.”

The proposed taxes include a jump in the current tax rate from 21% to 26.5% and global minimum tax rates on foreign income of 16.5%.

These new rates would hit earnings by 5%, assuming other things don’t change, and profit margins would need to jump by three quarters of a percentage point to offset the negative impact of the tax hike, the report says.

While an increase in profit margins is possible, it doesn’t seem probable. In other words, don’t count on corporate America to squeeze even more profits out of their companies in the next year.

And that should worry anyone with a stake in the stock market because lower tax rates have been a key driver in increasing ROEs since 1975. Ultimately, lower ROE will mean lower stock returns over time.