As the U.S. elections approach, a changing of the guard could deliver income headwinds through higher taxes, but an increase in the corporate rate can lead to stronger book values for banks with deferred tax assets.
Tax cuts, which passed in 2017, arguably represent President Donald Trump's marquee legislative accomplishment. Democratic nominee Joe Biden has proposed partially rolling back the lowered corporate tax rate, which fell to 21% from 35%. Biden proposes raising the corporate rate to 28%, and he said in a Sept. 10 CNN interview that raising corporate tax rates would be a "Day 1" priority.
Under Biden's plan, the nation's 10 largest banks could see their combined annual net income decline by more than $7 billion, according to an S&P Global Market Intelligence analysis that used the mean of equity analysts' estimates for 2021. The analysis also examined 209 publicly traded banks with at least three analyst estimates and found that a 28% tax rate would reduce the universe's aggregate annual income by $9.36 billion.
But there are a lot of ifs that need to occur before such a change could become a likelihood.
Biden needs to win the White House. Democrats need to win the Senate while holding onto the House. Then the legislators would need to agree to Biden's platform proposal if it is something that Biden decides to pursue.
"We need to always remember that politician promises on the campaign trail rarely come to fruition," said Isaac Boltansky, an analyst for Compass Point Research & Trading LLC.
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Historically, banks' tax bills have more closely matched the statutory tax rate than other industries, such as technology. That means any increase in the corporate tax rate will make a more direct impact on earnings. This could affect banks' valuations especially in the opinion of investors who focus on price-to-earnings multiples. Under the current tax regime and at current pricing, the analyzed universe of 213 public banks carry an 11.2x price-to-forward earnings multiple, excluding any pre- and after-tax unusual gains or losses. Increasing the tax rate to 28% would push the multiple up to 12.3x.
At the same time, investors have recently favored tangible book as the primary valuation metric as opposed to forward earnings. Through that lens, an increase in the corporate tax rate could serve as a positive for valuations considering some banks have significant deferred tax assets that could be more valuable following a tax increase. DTA represent future tax savings, which can help companies offset higher rates.
The impact of higher income taxes will not be uniform across the industry, but will depend on the net deferred tax for each institution. Banks regularly reevaluate deferred tax assets and liabilities. A tax rate increase will make deferred tax assets more valuable, providing a boost to earnings in the re-determination quarter, which would benefit tangible book values.
"Overall, it would be a negative to earnings, but ... it would essentially be a tiny capital raise amidst a dynamic in the bank space where investors have written off earnings multiple valuations and are really focused on the tangible book value," said Kevin Swanson, director of equity research for Hovde Group. "Any kind of little boost you can get, however small or large, is certainly a positive."
Citigroup Inc. has the most deferred tax assets in the banking industry at $23.87 billion, but many of the 807 publicly traded banks report deferred tax liabilities. Excluding Citigroup, the industry, in aggregate, has a liability, making Citigroup's asset larger than the sector-wide total of $20.77 billion.
Of course, banks will likely only need to consider the near-term impacts of a higher tax regime should Biden win the White House, which is no sure thing. And even if Biden wins, an increase in the corporate tax rate might not be feasible if Republicans retain control of the Senate. In that scenario, Boltansky puts the odds of an increase in the corporate tax rate at 60% and predicts it would likely be a smaller increase, in the range of 23% to 24%.
If Trump wins reelection, higher corporate taxes might be on the table toward the end of his second term, Boltansky said. The personal income tax cut from 2017 is due to expire in 2025, and — assuming Democrats still have control of the House — liberal lawmakers might be able to press for higher corporate taxes in exchange for retention of household tax cuts.
If Democrats take the House, Senate and White House in November, Boltansky said he does not expect the corporate tax rate to increase to 28%. He said the rate will almost surely increase but that he foresees a 25% or 26% tax rate. With the economy likely still struggling to recover from the pandemic-induced recession, Boltansky said moderate Democrats in conservative states, such as Sen. Jon Tester of Montana, would push back on a significant tax increase.
"It doesn't matter if Republicans agree. Can you get [Alexandria Ocasio-Cortez] and Tester to agree?" Boltanksy said.