Margins Up, Tax Down

BASED ON THE U.S. experience of the past 50 years, there appears to be a fairly tight connection between economic growth and stock returns. But the story is messier than it seems. While economic growth and per-share profits for the S&P 500 companies grew at a somewhat similar pace over the past 50 years, the growth in earnings per share received a significant boost from falling corporate tax rates and rising corporate profitability.

The top corporate tax rate has dropped from 48% in 1971-74 to 21% for 2018 and subsequent years. Thanks to complicated tax maneuvering, many companies manage to pay even less. As corporate income taxes have fallen and profit margins have widened, after-tax corporate profits have grown from 7.6% of GDP in early 1974 to 11.2% in early 2024, according to data compiled by the Federal Reserve Bank of St. Louis.

Trouble is, falling corporate taxes and widening profit margins are onetime gains. Stock investors can’t benefit again from after-tax corporate profits rising from 7.2% of GDP to 11.1%—unless there was a sharp contraction first. That doesn’t mean tax rates couldn’t fall further and profit margins couldn’t widen further. But there are limits to both. Corporate taxes can’t get any lower than zero. Meanwhile, the share of GDP that goes to corporate profits, which comes at the expense of salaries and wages, can’t keep growing and growing.

A further reversal would be grim news for stock market investors. Over the past 50 years, the combination of falling taxes and rising profitability has helped offset one of the most insidious threats to stock market investors: dilution.

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