Higher corporate taxes sinking the S&P 500 isn't your biggest stock-market worry

By Mark Hulbert

About half of large U.S. corporations don't pay any income tax in an average year

Tax-rate changes don't have as big of an impact on corporate profits, and in turn the stock market, as the headlines suggest. So you can stop being concerned about the fate of the Tax Cut and Jobs Act of 2017.

This Trump-administration initiative reduced the U.S. corporate tax rate to 21% from 35%. Much of the TJCA is set to expire at the end of 2025. Former President Donald Trump supports extending the TJCA, while Vice President Kamala Harris supports increasing the top corporate income-tax rate to 28%.

The reason why investors can focus on other concerns is that the headline tax rate is just one of many parts of the U.S. tax code that affect a corporation's tax liability. Myriad possible credits can offset the tax that is otherwise due, for example, and a corporation won't pay any income tax if it isn't profitable. According to a Government Accounting Office study, in the wake of the TCJA, about half of large corporations don't pay any income tax in an average year. Even among profitable corporations, according to the GAO study, 25% don't pay any corporate tax in an average year.

Pricing power and profitability

The other part of the answer is that corporate profit margins are a function of factors more impactful than taxes. Take a look at the chart above, which plots the S&P 500's SPX profit margin over the past 25 years. Notice that the margin's uptrend was well in place prior to the 2017 tax cuts, and despite considerable volatility since those cuts took effect, the latest margin is only slightly above that trendline.

What are those other factors? One, according to Lawrence Tint, is the increasing pricing power that companies have acquired in recent decades, which enables them to maintain their profit margins within a relatively narrow range from year to year. Tint is the former U.S. CEO of BGI, the organization that created iShares (now part of BlackRock). Tint said in an interview that this increasing pricing power traces to a number of factors, such as many industries becoming oligopolies - with just one or two large companies having the bulk of market share. He predicts that if corporate tax rates are increased, corporations will be able to pass their higher costs to consumers by raising prices.

An illustration of this pricing power is profit margins' remarkable steadiness in the wake of inflation's recent spike. The U.S. Consumer Price Index's lowest annual rate of increase over the past couple of years was in 2020; in the fourth quarter of that year the S&P 500's profit margin was 10.9%. At no point since then has the profit margin been more than one-tenth of a percentage point lower.

Profit slowdown

This doesn't mean corporate profit margins have no upper limit, according to Rob Arnott, the founder and chairman of Research Affiliates. In an interview, he said that profit margins over the past century have fluctuated according to a several-decade cycle. When they rise too far, too fast, there is a political/social/economic backlash that causes margins to stop growing or even decline. He predicts that, because corporate earnings over the past decade and more have grown at one of their fastest rates in history, they are likely to grow only slightly in coming years - if at all.

In an interview, Arnott said that his prediction is not dependent on whether or not corporate tax rates are kept at today's levels. He added, though, that it wouldn't surprise him if the corporate tax rate is increased in coming years and is blamed for corporate earnings growing slowly or not at all over the next decade. The real story will be far more complex, of course.

If profit margins don't increase from current levels, then corporate earnings can grow no faster than sales. And as I argued in a column two months ago, the stock market's sales per share over the long term have grown more slowly than GDP. Since 1954, for example, the S&P 500's sales per share have grown 0.6 of an annualized percentage point more slowly than U.S. GDP.

If the future is like the past, this history translates into a modest forecast of future return, since the Congressional Budget Office is projecting that U.S. GDP over the next decade will grow at a 1.8% annualized inflation-adjusted rate. If sales lag GDP by the same amount, then corporate earnings will grow at a 1.2% annualized rate between now and 2034.

The stock market could grow faster than earnings if its price/earnings multiple were to widen from current levels. But that seems unlikely, since its P/E ratio is already far higher than historical averages. As I pointed out last week, the S&P 500's forward P/E currently is higher than in 99% of the months since 2000.

The bottom line, according to Arnott: "It's not difficult to imagine a scenario in which U.S. large-cap equities don't even match inflation over the next decade."

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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09-27-24 1242ET

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