The Economic Impact Of Tax Policy

by: David Pope - S&P Capital IQ

The news headlines over the last few weeks have been littered with tax proposals. Proposals range from taxing the very wealthy at a higher rate, raising the tax rate on dividends, to taxing corporations at a lower rates and closing loopholes.

Certainly changes to tax policy matters at the individual and entity level, but what impact does tax policy have in aggregate?

What will the impact on economic growth be? If economic growth is impacted, earnings are likely to follow. The market will then react in anticipation of the earnings impact.

I was talking to an old friend a while back and he made the point that tax rates and GDP are uncorrelated. I decided to look at it myself.

I struggled with what tax rate to use (Top marginal, average, etc). I settled on the total tax receipts as percent of GDP. For GDP I use real GDP. I use quarterly data covering 1947 - 2011.

The Correlation between the tax rates and GDP is .028 with a t-stat of .45. Statistically we can say that this is not a meaningful relationship.

To determine the relationship between GDP and tax rates, I quintiled Real GDP and looked at the average and median tax rates for each quintile:

GDP Sensitivity to Tax Rate 1947-2011

On the surface, there appears to be little distinction between tax rates and the corresponding rate of real GDP. Should we be surprised? Not really, notice that in the formula for GDP there is no explicit mention of taxes. Presumably private consumption would go down with higher taxes but this would be offset by increases in government spending.

GDP = private consumption + gross investment + government spending + (exportsimports)

Why do we even care about how GDP and Tax Rates correlate to each other? Answer: Over the long run company earnings track GDP.

But in the end we care about stock returns. When I quintile the tax receipts as percent of GDP I find that the best S&P500 returns occur in periods of both HIGH and LOW tax rates. Not only is economic growth insensitive to tax rates, but stock returns appear to be as well.

Examining at where the tax receipts come from by segment, we see that reductions in the corporate tax receipts have been made up by increasing social security receipts.

click to enlarge

US Tax Revenue as a Fraction of GDP by Component

Source: Department of Numbers

While tax rates and tax receipts by segment trend over time, the total receipts as a percentage of GDP is quite stable (perhaps surprisingly so).

Government Receipts and Expenditures as a Fraction of GDP

Source: Department of Numbers

What does all this imply? While changes in tax policy matters if you pay taxes, GDP and thus earnings - and stock returns by extension - are generally unaffected.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.