Today, we are pleased to present a guest contribution written by Daniel Soques (University of North Carolina Wilmington). The views presented represent those of the authors alone and do not reflect the views of their respective institutions.

A recent CNBC survey found that Wall Street investors largely believe a Biden presidency could mean lower stock market returns (https://www.cnbc.com/2020/12/28/investors-believe-the-stock-market-could-see-headwinds-under-a-biden-presidency-.html). Despite this view, the S&P 500 is up 11% since Election Day, with much of the focus on the announcement and roll-out of the various COVID-19 vaccines. But what should investors expect when the market’s attention turns back to standard macroeconomic policy issues, such as a potential tax increase?

To get a better sense of how the stock market is likely to respond to a change in tax policy, investors can look to what happened after the 2016 election.  The conventional wisdom is that Trump administration policies played an important role in the 25% increase that was observed over the following year.  And this concurs with President Trump’s view, “The reason our stock market is so successful is because of me,” as he stated on November 6, 2017. In a recent paper (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3727719), myself along with coauthors Anthony Diercks (Federal Reserve Board) and William Waller (Tulane University) evaluate this narrative in a comprehensive and exhaustive forensic analysis of this time period.

We analyze major financial news stories to make judgments about primary drivers on each of the 283 days between the 2016 election and the signing of the TCJA in late 2017. For robustness, we also conduct a machine-driven textual analysis based on the Bloomberg News Trend Function.  We conclude that tax news did play a positive role in the observed increase, confirming the president’s assertion about the performance of the stock market.  However, we find that the 52 days in which tax news was most important only contribute 1 – 2.5%, on net, to the 25% market return.  Instead, days associated with U.S. economic data, earnings, and news about monetary policy contributed a greater share to the large rise in the stock market.

Figure 1: Daily Human Attribution – This figure shows the category for which each day’s return is attributed based on our human-audited news approach. The height of each bar shows the daily CRSP value-weighted index returns from November 9, 2016 to December 22, 2017.

Figure 2: Days Attributed to Tax Policy News – This figure shows the returns for each day attributed to tax policy news based on our human-audited news approach. The height of each bar shows the daily CRSP value-weighted index returns from November 9, 2016 to December 22, 2017.

We argue that existing studies which focused on the beginning and ending of this time period provide an incomplete picture.  That’s because they miss key events that took place in the summer of 2017, when the prospect for tax legislation seriously declined following multiple failures to pass healthcare legislation and the announcement of Robert Mueller as special counsel.  Each of these events reportedly led investors to question the administration’s ability to pass tax legislation and were associated with the largest declines in the stock market over this time period.

Figure 3: This figure shows the probability of tax legislation based on the PredictIt market. The red line shows the probability of new corporate tax legislation by the end of 2017. The blue line shows the probability of new individual tax legislation by the end of 2017.

Further calling into question the importance of taxes over this window, we show that the Goldman Sachs High minus Low Tax Basket ended up lower, on net, indicating that high tax firms actually may have underperformed low tax firms.

Figure 4: This figure shows the relative return of high tax firms compared to low tax firms. The green line shows the cumulative return for the Goldman Sachs portfolio that goes long in the 50 highest-taxed S&P 500 firms and short in the 50 lowest-taxed firms. The blue line shows a similarly-constructed portfolio using all publicly-traded firms based on the quartiles of cash taxes paid.

How could a 14 percentage point drop in the corporate tax rate only translate to a 1-2.5% increase in the aggregate stock market? We illustrate through a simple Gordon Growth discounted cash flow model that this counter-intuitive result could be explained by four factors. First, most firms were not paying the statutory tax rate before the TCJA due to a number of loopholes and other deductions. Second, the legislation also included new limits on net interest deductions and the repeal of several other deductions in an attempt to broaden the base. Blanchard et al. (2018) and Wagner et al. (2020) find that the effective corporate tax rate fell only 4 to 5 percentage points. Third, investors likely did not view the corporate tax cut as permanent. Even assuming a relatively long horizon of 50 years for the TCJA corporate tax rate considerably reduces the implied return in the model compared to assuming a permanent rate cut. Lastly, a modest response from monetary policy (due to inflation concerns) would drive up the discount rate and reduce returns. The FOMC did in fact increase its SEP projections in the meeting following the election by 25 basis points. After accounting for these four factors, the modest stock market effect of the TCJA is perhaps unsurprising.

So if taxes weren’t the driver of the run-up in the stock market during 2017 then what was? Our analysis finds that global growth played a substantial role. For example, the Eurozone and China were having some of their best economic performances in over half-a-decade.  Likewise, the value of the dollar fell dramatically in 2017 — coinciding with the decline in the prospects for tax legislation — and this boosted multinationals (40% of revenues for S&P 500 is foreign) and export demand for manufacturers. Additionally, we argue the deregulatory policies of the Trump Administration may have also been a factor in boosting stock market returns.

This new paper speaks directly to investors’ concerns about the stock market effects of a potential Biden tax increase. Our findings imply that the prospect of future tax increases will likely be associated with a lower stock market.  However, our analysis also suggests that the net effect of a tax hike on the stock market is likely to be very modest.  All in all, other macroeconomic factors, such as U.S. economic data, global economic data, and factors related to the COVID-19 pandemic will likely play a relatively larger role in determining the performance of the overall stock market moving forward.

This post written by Daniel Soques.