The American electorate handed Republican nominee Donald Trump a decisive victory over his Democratic rival Kamala Harris on Nov. 5, sending the former President back to the White House for a second term. The three major U.S. stock market indexes hit record highs the next day, and the S&P 500(SNPINDEX: ^GSPC) has advanced 3.5% since the ballots were tallied.
That momentum reflects expectations that a second Trump administration will bring about changes in fiscal policy that keep the stock market in growth mode. After the election, Yardeni Research analysts wrote, "We expect that the S&P 500 profit margin will rise to new record highs of 13.9% and 14.9% over the next two years thanks to Trump's corporate tax cut, deregulation, and faster productivity growth."
Investors should bear in mind that the president does not control the stock market, but they can influence the economy through budget proposals and appointments. And history shows that corporate tax cuts could send the S&P 500 higher.
History says S&P 500 could soar following a reduction in the corporate tax rate
During his campaign, President-elect Donald Trump discussed several policy changes that could impact the stock market. One of the most noteworthy was a proposed reduction in the federal corporate tax rate from 21% to 15%, which would be the lowest level since the mid-1930s.
The S&P 500 is widely regarded as the best barometer for the entire U.S. stock market. When the index was created in 1957, U.S. companies were taxed at 52%, but the corporate tax rate has since been cut six times. The most recent reduction came in 2018, the year after Trump signed the 2017 Tax Cuts and Jobs Act (TCJA) into law during his first presidency.
The chart below shows the S&P 500's 12-month return following the last six reductions in corporate taxes.
Year Corporate Tax Cut Takes Effect | Annual S&P 500 Return (12 Months) |
|---|---|
1970 | 0% |
1971 | 11% |
1979 | 12% |
1987 | 2% |
1988 | 12% |
2018 | (6%) |
Average | 5.2% |
Data source: Internal Revenue Service, YCharts.
As shown above, the S&P 500 has returned an average of 5.2% during the 12-month period following past reductions in the federal corporate tax rate. Comparatively, the index has returned 11% annually over the long term, according to Goldman Sachs.
The idea that a lower corporate tax rate would lead to below average returns in the stock market is somewhat counterintuitive. After all, larger profits should let companies spend more on marketing, product development, and capital expenditures. Alternatively, companies could return excess profits to shareholders with dividends and stock buybacks.
Any of those changes could conceivably drive the market higher, but the positive impact may take longer than 12 months to materialized. So, the chart below shows the S&P 500's annual return during the 24-month period following the last six reductions in the corporate tax rate. This time there is a correlation between tax cuts and above-average gains in the stock market.
Year Corporate Tax Cut Takes Effect | Annual S&P 500 Return (24 Months) |
|---|---|
1970 | 5% |
1971 | 13% |
1979 | 19% |
1987 | 7% |
1988 | 20% |
2018 | 10% |
Average | 12.3% |
Data source: Internal Revenue Service, YCharts.
As shown above, the S&P 500 returned an average of 12.3% annually during the 24-month period following the last six reductions in the corporate income tax rate. That exceeds the long-term average of 11% annually.
In other words, while the impact may be minimal during the first year, history says Trump's plan to reduce corporate taxes could ultimately lead to above-average returns in the U.S. stock market.
A lower corporate tax rate could also create problems for the stock market
While reducing corporate taxes may be a good thing for stocks, at least initially, it could have negative consequences down the road. For instance, if corporate profits were taxed at 15% rather than 21%, federal revenue could decline by as much as $673 billion over the next decade, according to the Committee for a Responsible Federal Budget.
That could drag the U.S. government deeper into debt through greater deficit spending, which could lead to a downgrade from one (or all) of the three major credit rating agencies: Fitch, Moody's, and S&P Global. If that happens, the U.S. government would likely find it more difficult to sell Treasury bonds because prospective buyers (i.e., lenders) would be less confident in the government's ability to repay them.
That could create a vicious cycle. The prospective buyers would demand higher and higher interest rates on Treasury bonds as they take on more risk, which itself would increase the likelihood that the U.S. government ultimately defaults on its debt. If that happens, the consequences for the stock market and broader economy would almost certainly be dire.
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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group, Moody's, and S&P Global. The Motley Fool has a disclosure policy.
