For the Stock Market, Taxes Trump Stimulus

In the corridors of Congress, the sausage-making process is in full swing. The scale, scope, and content of the Democrats' budget reconciliation package are all on the line. The specifics of the business tax hikes may be more important to investors than the final spending numbers.

The House budget committee advanced a roughly 2,500-page draft of the plan this week, totaling $3.5 trillion in additional spending and tax credits, offset by tax increases on corporations and the rich.

The bill will very certainly fail to pass in its current form. That level of spending does not sit well with congressional moderates. Sen. Joe Manchin of West Virginia, a key Democrat, prefers $1.5 trillion, while members of the Congressional Progressive Caucus argue that they have already cut back their objectives to reach the $3.5 trillion amount. They've reached a stalemate for the time being.

Economists at Wells Fargo Securities expect a compromise to emerge, one that lands somewhere in the middle, as compromises normally do. The price tag would be in the range of $2 trillion to $2.5 trillion. Although this is still a substantial sum, it will be divided over the next decade and offset by higher taxes. In the end, the economic impact in any given year will be minimal. After all, the annual gross domestic product of the United States is around $23 trillion, so it takes a lot of extra expenditure to move the needle. “We suspect that with a package like this, we would measure changes in our forecasts for economic growth and inflation over the next year or two in tenths of a percentage point, in contrast to the much larger changes we made to our forecast in the aftermath of the American Rescue Plan...earlier this year,” writes Michael Pugliese of Wells Fargo.

Nonetheless, the combined impact of a budget reconciliation bill and the concurrent bipartisan infrastructure proposal, which adds another $550 billion in new expenditure to the mix, would influence a wide range of companies. Manufacturers of electric vehicles, as well as battery and charging station manufacturers, are among them. Subsidies for insurance plans purchased through state marketplaces would be increased, which would benefit health insurers. Drugmakers and distributors would have to deal with drug pricing reforms and the government's ability to negotiate prices. The spending will be spread out over a decade once more, with the details still to be worked out.

Taxes, on the other hand, will be implemented nearly immediately. The highest corporation tax rate will rise to 26.5 percent from 21 percent in the House Budget Committee's draft, while the top marginal income tax rate will rise to 39.6 percent from 37 percent, and the long-term capital gains tax rate will rise to 25 percent from 20 percent. Other tax changes for corporations and individuals bring the total new tax revenue in the draft to over $2 trillion. A higher corporate tax rate alone would chop several dollars off the $217 per-share earnings prediction for the S&P 500 in 2022. That's bad news for an earnings-driven market already weighed down by lofty expectations.

Taxes are a good place to start—and end—if you're wondering what the reconciliation bill will entail for the market.