Have investors anticipated a rise in corporate tax?

When Chancellor Rishi Sunak unveils the UK budget for 2021 on Wednesday March 3, we should have a clearer picture of how the UK government plans to start paying for the cost of Covid-19.

The Treasury has so far borrowed more than £300bn to fund emergency economic support for pandemic-hit workers, homebuyers and businesses, racking up a bill that Sunak called “morally, economically or politically” unsustainable.

Unfortunately for the Chancellor, government promises made in the 2019 general election – just months before everyone’s plans were upended – leave limited scope to raise income tax rates, contributions national insurance or value added tax.

Together, so-called “triple lock” taxes contributed 73% of Treasury revenue in 2019, according to HMRC, making them the most important tools in the tax kit needed to balance spending. However, Sunak refused to break away from the Conservative manifesto pledge, putting corporation tax – which contributed 9% of tax revenue last year – in second place.

In recent days, several reports have emerged from Westminster suggesting that corporation tax will rise from 19% to 25% by the end of the current Parliament in 2025.

This has obvious implications for investors in UK domestic equities, as corporate profits are reported net of tax. A 6 percentage point rise in earnings would therefore depress earnings expectations in coming years, reducing companies’ ability to invest, distribute dividends, buy back and repay debt.

A revision of tax forecasts is also likely to adversely affect the net present value of assets, as a higher discount is applied to the future value of cash flows. This is likely to be negative for stock prices.

Although calculating a company’s tax burden in any given year is complicated by the various levies it may be subject to, it is still possible to roughly model the immediate impact on profits.

Take the real estate portal online Move right (RMV), which detailed a consolidated effective tax rate of 18.5%, just below the current standard corporate rate of 19%, when it reported its annual results on Friday.

The group attributed this to credits received in connection with research and development expenses, although the company’s national focus, lack of debt and carried forward losses, limited operating expenses and business model lean business make this a relatively simple example for calculating potential tax effects in the UK. changes.

Right now, however, consensus forecasts don’t factor in much of tax hikes, according to FactSet. In fact, city analysts expect the tax rate to decline over the next three years, both on a stated and adjusted basis.

So far, news reports have suggested that a corporate tax hike would be phased in, perhaps through 2 percentage point increases in 2022 and 2023. Here we model the effect on reported earnings of a 1 point increase in 2021, and 1.5 point increases thereafter, to roughly estimate the effect on net income:

On such a limited time horizon, the difference is not obvious. Shareholder profits for the next three years would fall just 3.5%, to £537m. However, this figure drops to £514m if corporation tax were to be raised at the suggested maximum rate all at once:

This gives an idea of ​​the compounding effect on future earnings and the effect this is likely to have on the market value of a company that is already priced at 35 times this year’s adjusted after-tax earnings. Such an assumption is also not so drastic, given the magnitude of the challenge facing the chancellor in raising government revenue. A 6 percentage point rise in corporation tax, for example, is unlikely to bring in more than an additional £80bn over the next five years, according to an RBC study of possible ways Sunak could increase treasury chests during the legislature (see table, below).

Fortunately for the Chancellor, a rise in the corporate tax rate has broad public support, including among a majority of Conservative and Labor voters, according to a recent poll by Kekst CNC. Whether a political consensus can be reached in parliament is less clear, however, after Labor leader Keir Starmer and a string of Tory backbenchers signaled their opposition to the proposed raise, arguing that it could hamper an economic recovery.

Others have suggested the government take a more targeted approach and focus on taxing companies that have become more profitable during the pandemic, although this may introduce an element of moral hazard and is unlikely to be good news for investors who have reoriented their portfolios towards companies less exposed to the effects of confinement and the recession.

One such haven has been high-flying U.S. tech stocks, although news that President Joe Biden’s administration is proposing to raise the corporate tax rate from 21% to 28% – while providing a hedge additional to the UK government – is likely to prove a new challenge to bullish earnings expectations for the economic recovery.