The subtle reason why stocks could fall if Kamala Harris raises corporate tax rate by 33%

Less than a month from today, on November 5, voters will go to the polls to determine which presidential candidate – current Vice President Kamala Harris or former President Donald Trump – will lead our country for the next four years.

Admittedly, not every decision made in the Oval Office or by our elected officials in Congress has an impact on Wall Street. However, the economic policies introduced by the new president and Congress may affect corporate profits and, therefore, the stock market.

While both candidates’ economic proposals have potential advantages and disadvantages, the one plan that is raising many eyebrows on Wall Street is Harris’ call to raise the corporate tax rate by one-third – from 21% to 28%.

Although the current U.S. corporate tax rate is at its lowest level since 1939, raising it by 33% could cause a stock market crash for a very unexpected reason.

Vice President Kamala Harris talks to reporters. Image Source: Official White House Photo by Lawrence Jackson.

Stocks Could Fall if Harris Raises the Corporate Tax Rate – But Not for the Reason You Might Think

Kamala Harris’s plan to increase corporate taxes stems from persistent and growing federal deficits.

With the exception of 1998–2001, the federal government has spent more than it has taken in in revenue in every year since 1970. The national debt currently stands at approximately $35 trillion, and the annual cost of servicing that debt is approximately $1.05 trillion. as of August 2024, according to the U.S. Department of the Treasury. This trajectory will not be sustainable in the long term.

Based on Treasury Department estimates, increasing the corporate tax rate by one-third to 28% would increase federal tax revenues by a total of $1.35 trillion over the next decade.

However, increasing corporate taxes could have unintended and/or unforeseen consequences for Wall Street.

The logical expectation with an increase in the corporate tax rate is that businesses will have less capital to invest in the meat and potatoes that fuel their businesses. In particular, we will see slower hiring rates, fewer acquisitions, and less capital expenditure on research and development. Hiring, acquisitions and innovation are usually what increase corporate profits.

But there is a less obvious concern that could cause share prices to plummet if the corporate tax rate increases by 33%. Less available capital to deploy in publicly traded companies could reduce or eliminate what has been a key source of earnings growth in recent years: share buybacks.

The share buyback boosted profits for Apple and many of Wall Street’s largest companies. purchase of AAPL shares (quarterly); data according to YCharts.

For companies with stable or growing net income, share repurchases can increase earnings per share (EPS). As a company’s number of shares outstanding decreases, its EPS should increase, thus making it more attractive to investors.

In the next 12 months (TTM) period ending March 2024 S&P500 (SNPINDEX: ^GSPC) companies made $816.5 billion in buybacks, which is technically down from the TTM peak of $1.01 trillion in the period ended June 2022, based on data from S&P Global.

More importantly, 50.9% of buybacks completed in the first quarter of 2024 were among the 20 largest companies by market capitalization in the S&P 500. Buybacks have been used to fuel earnings growth of America’s largest and most influential companies, but it is continuing if Harris wins in November and has the votes on Capitol Hill to raise the corporate tax rate by one-third.

For example, the world’s largest publicly traded company by market capitalization, Apple (NASDAQ:AAPL)since the beginning of 2013, it has repurchased $700.6 billion of its common stock, thereby reducing its outstanding shares by 42.2%.

If Apple hadn’t repurchased a single share over the past 11 years, its consensus EPS for fiscal 2024 (ended Sept. 30) would have been less than $4, rather than the current $6.68. Perhaps no company’s performance in recent years has been as driven by stock buybacks as Wall Street’s largest public company.

If there is any consolation on this point, Fidelity’s study found that the S&P 500 benchmark rose an average of 13% after each corporate tax increase since 1950. While this does not guarantee a rise in stock prices if Harris raised the corporate tax rate from 21% to 28%, history clearly favors a continuation of the current bull market.

Image source: Getty Images.

This may be even more concerning than the prospect of a reduction in stock buybacks

While share repurchases have been artificially boosting the EPS of Wall Street’s largest companies for years, and a higher corporate tax rate may slow share repurchase activity, this may not be Wall Street’s most pressing concern. Rather, the historically expensive stock market could be the catalyst that sends stocks toward a correction or bear market, regardless of who is elected president on November 5.

Honestly, investors can measure value in many ways, and everyone has a different level of risk tolerance. However, based on Shiller’s price-to-earnings (P/E) ratio readings for the S&P 500, we have seen only a handful of times in over 150 years where stocks have been this expensive overall. The Shiller P/E ratio is also called the cyclically adjusted price-to-earnings ratio or CAPE ratio.

Most investors rely on the traditional P/E ratio as a quick and easy way to determine whether a stock is relatively cheap or expensive compared to other companies and its own history. However, the traditional P/E ratio only takes into account TTM earnings, which may be distorted or adversely affected by shock events such as temporary lockdowns that occurred during the pandemic.

The Shiller P/E ratio is based on average inflation-adjusted earnings over the previous 10 years. Taking into account a full decade of EPS history minimizes the impact of shock events, leading to a more accurate measurement of value.

S&P 500 Shiller CAPE Index; data according to YCharts..

When the closing bell rang on October 3, the Shiller P/E for the S&P 500 was 36.6, more than double the average reading of 17.16, backtested to January 1871. Despite lower interest rates and democratizing access to Internet of information has increased the willingness of ordinary investors to take risk, Shiller’s P/E ratio of almost 37 is an excessive reading.

Looking back to 1871, there have only been a total of six times in which the S&P 500’s Shiller P/E has exceeded 30 during bull markets, including the current situation. After five previous S&P 500 events, Dow Jones Industrial Average (DJINDICE: ^DJI)and/or Nasdaq Composite (NASDAQINDEX: ^IXIC)they lose from 20% to 89% of their value.

While Shiller’s P/E is not a timing tool – i.e. stocks can remain expensive for weeks, months, and in rarer cases, many years – he has an unerring track record of predicting big declines in the S&P 500, Dow, and Nasdaq Composite.

While Kamala Harris’ plan to raise the corporate tax rate by 33% is likely to be bad news for Wall Street, investors’ biggest enemy right now is historically expensive stock valuations – and that’s unlikely to change anytime soon.

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Sean Williams has no position in any of the companies mentioned. The Motley Fool holds positions in and recommends Apple and S&P Global. The Motley Fool has a disclosure policy.