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Chart In Focus

Taxes Will Bite the Stock Market

Chart In Focus
February 14, 2024

If you want to know what future federal tax collections are going to look like, just look at what the stock market has done over the past 12 months.  I figure that the Congressional Budget Office does not know about this trick.  This week's chart shows the SP500, shifted forward by a year.  The lower line represents the 12-month trailing total of federal tax receipts.  I use the 1-year time offset to help illustrate how tax collections lag whatever the stock market does a year earlier. 

This relationship is meaningful because it says that federal tax collections should start rising rapidly, a rise which should last for at least the next 12 months, since the SP500 has just made new all-time highs.  If the stock market turns down, then the Treasury Department can start looking forward to lower tax receipts.  Total tax collections in raw dollar terms bottomed in October 2023, exactly 12 months after the stock market’s October 2022 bottom.  Now that the SP500 has moved to a new all-time high, it is fair to expect that taxes are also going to rebound quickly, as the April tax filings come in, and as those readjusted quarterly estimated payments start happening at higher levels.

But there is a little bit of circular logic and feedback in this relationship, because the level of tax collections also affects how the stock market does.  This is an topic that is going to come up for the stock market very soon.

When Americans file their income tax returns this coming April, most investors will have taxes due on their 2023 capital gains, and that is going to mean higher quarterly estimated payments throughout 2023.  This is because the calculation of those quarterly estimated tax payments varies based on how much a taxpayer was under-withheld for the prior year.  So a taxpayer who had capital losses during the bear market of 2022 might have had very low quarterly estimated payments to make during 2023.  And now that taxpayer is likely going to be reporting a gain for 2023, which will drive up the quarterly estimated payments in 2024.

Paying more in taxes means that the extra money people have had is not going to be around any more to help lift the stock market, and instead Uncle Sam (and Janet Yellen) will have it.

That’s good for the nation’s accumulating debt, but not for the path of the stock market.  This next chart shows that total federal tax collections still remain very low at just 16.1% of GDP, and that is stimulative.  But when those additional taxes get collected starting in April, this is likely to go up and be less of a stimulative force.

federal tax receipts as percentage of gdp

We are currently seeing a very low rate of tax collections measured as a percentage of GDP.  Getting taxes down to 16% of GDP has always been very stimulative.  But getting taxes up to 18% of GDP has brought an economic recession every time that it has happened, including in 2022 which did see two consecutive quarters of falling GDP (for those who like that definition of a recession).  If taxes go up a bunch like the SP500 says they will in the top chart, that can be okay for this ratio as long as GDP goes up by a corresponding amount.  Taxes and GDP going up or down together keeps the ratio constant.

But if GDP slows, as Fed Chairman Jerome Powell says he believes it will, and if the tax collections go up as the SP500 says they will, then we have a condition where this ratio changes quickly to a very adverse one for stock prices.

You may notice that in the late 1990s, taxes got up well above 18%, and the SP500 kept on going higher.  That is an important observation, and it shows that the effect of high tax collections on the stock market can take a while to be felt.  But 1998 was unusual in that the NYSE's Advance-Decline Line peaked in April 1998, well ahead of the SP500 and other indices, as a majority of stocks started doing poorly under the higher tax load.  The big-cap indices kept doing okay because what liquidity there was available to invest was getting channeled into the fashionable new Internet stocks.  Eventually the high taxation did what it always does, and it brought down both the stock market and the economy during the recession of 2001-02.

If 2024 brings a combination of rapidly rising tax collections and a slowing economy, then this tax receipts to GDP ratio could quickly jump up close to that 18% threshold, making things much more difficult for the stock market.

Tom McClellan
Editor, The McClellan Market Report

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