What impact will artificial intelligence (AI) have on corporate earnings?
Artificial intelligence has previously been and will undoubtedly continue to be a topic for “Capital Ideas.” I recently attended an AI conference and thus have a unique opportunity to sum up AI’s potential impact on the economy.
AI is not going to take my job or replace my coworkers, but it is going to make us all more efficient. Companies will be able to scale, which means that the growth rate of revenue will exceed the growth rate of cost. That translates to increased corporate margins, allowing multiple expansions and higher stock prices.
Let’s deconstruct AI’s connection to the market. That connection is profits. From December 31, 2019, to the end of the third quarter of 2024, the S&P 500 was up 92 percent. Of that 92 percent, 57 percentage points came from profits, and 14 percentage points came from dividends. So, a total of 71 out of that 92 percent, more than three-fourths, came from fundamentals—corporate earnings and companies returning profits to shareholders in the form of dividends.
The rest of that 92 percent was multiple expansion, which intuitively makes sense—valuations go up in a bull market, not down. However, less than a quarter of the market’s growth over roughly five years is from the oomph of investor optimism, which suggests the market is a long way from a bubble. Valuations and optimism deservedly rise with the scale of corporations. We are in the very early stages of AI helping companies scale, which will support corporate earnings and stock prices.
How might Vice President Harris’ proposal to raise the long-term capital gains tax rate (LTCGTR) to 28 percent affect the stock market?
Before we get into it, note two things:
- LTCGTRs currently have a maximum of 20 percent; gains are considered long-term if held over one year.
- My calculator does not vote Democrat or Republican. This is math (and history), not a political discussion.
There are multiple long-term capital gains rates, depending on an investor’s situation. Since there is already so much going on, let me simplify the current tax rate grid with round numbers. You can look up specifics here if you would like to.
- If you are married, filing jointly, and earning less than $90,000, the LTCGTR is zero percent.
- If you are married, filing jointly, and earning less than $550,000, the LTCGTR is 15 percent.
- If you are married, filing jointly, and earning more than $550,000, the LTCGTR is 20 percent.
Harris would raise the LTCGTR to 28 percent for those married, filing jointly, and earning more than $1 million. (Harris would also increase the Additional Net Investment Income Tax, NIIT, from 3.89 percent to five percent, but this is all complicated enough, so just know that the increase is more than what is directly stated in the proposal.)
The Tax Foundation expects the higher rate to reduce Gross Domestic Product (GDP) by 0.2 percent. Honestly, that is as good a guess as I could come up with. There is so much to consider, not the least of which is that new legislation would not occur in a vacuum—there are many variables.
I have done the work on the tax question internally. Still, I am always hesitant to share stuff like this because some people are politically minded and if math contradicts a non-nuanced ideology, they have got to tell me about it. But let’s not let them ruin it for the rest of us.
Also, planning for the specific math of it all is stupid. Admittedly, that is intentionally harsh to make a point. As President Dwight Eisenhower said, “Plans are useless, but planning is indispensable.” A plan may not be worth much once reality sets in, but the act of planning itself is valuable. Planning can help you develop situational awareness and a flexible strategy.
To assess how a change in the capital gains rate could affect the stock market, you must consider its impact on the broader economy. What would be its effect on capital formation? Will there be less innovation because entrepreneurs are disincentivized to enter the market? Will small business owners resist selling their companies and just let them die on the vine, and what negative consequences would that have?
Does it matter that over one-third of those investments are in tax-deferred accounts? And if the most affluent hold most stocks in taxable accounts, how does it affect discretionary spending? And what of the workers in those segments that could take a hit?
Or perhaps higher tax rates help investors because their biggest enemy is themselves—making irrational decisions such as buying high and selling low. Do higher rates nudge investors to become more rational and thus become better investors? And does it even matter? Depending on the methodology, the estimated average holding period for individual investors is less than one year anyway, making long-term capital gains taxes moot for that segment.
Are there short-term negative behavior adjustments? For instance, sellers could rush to the door to lock in lower tax rates. Over the long term, would there be a preferential shift to tax-efficient investment and accounts, thus negating the negative impact?
Net-net, everything else equal, the mathematics of higher capital gains rates are clearly negative for investors. Higher tax rates are likely harmful to investors even if everything else is not held constant. The real question is, by how much?
The last time the long-term capital gains rate was 28 percent was May 7, 1997, when the Taxpayer Relief Act of 1997 reduced it to the current rate of 20 percent. The Tax Reform Act of 1986 set the maximum LTCGTR at 28 percent, meaning the rate was at Harris’ proposed rate for approximately 11 years. The average return for the S&P 500 during that period was about 17 percent. Not too bad.
Of course, comparisons are far from apples-to-apples. For instance, considering Harris’ five percent NIIT proposal, the combined capital gains rate for top earners would actually be 33 percent, the highest rate since 1978, when it was close to 40 percent. Over the decades, the capital gains rate has been structured differently, with unique exclusions and modified holding periods, making accurate comparisons impossible. Still, the average return of the S&P 500 for the 50 years before the Tax Reform Act of 1986, when tax rates were mostly higher, was approximately 10.5 percent per year. Also, not too bad.
The interaction between tax policy and market performance is complex and influenced by numerous variables. While there is some theoretical basis to suggest that capital gains tax rates could influence stock market performance, empirical evidence shows that the correlation is not strong or consistent over time. Economic conditions and corporate performance are seemingly more significant drivers of stock returns than capital gains tax rates. Artificial intelligence to the rescue?
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
