Democrats Sweep in Georgia to Win Senate Control--Now What?
Corporate business taxes set to rise, but not up to 2016 levels.
Democrats pulled off an improbable double victory in Georgia, winning both special elections, an outcome we pegged at around a 20% possibility. With the Democratic candidates’ wins, the Senate makeup will be 50 Democratic senators and 50 Republican senators, with Democratic Vice President-elect Kamala Harris acting as a tiebreaker in votes.
Democrats already hold a majority in the House of Representatives, so the victories in the Georgia races mean President-Elect Joe Biden will likely have an easier time with at least some of his agenda under the new Senate control.
We think the biggest effect a Democrat-controlled Congress could have on investments is a likely increase in the corporate business tax rate, probably up to 28%, with fewer or no changes in the rate paid on offshore income. Such a change would likely be for the 2022 tax year.
We also think this new Senate majority opens up possibilities for changes in energy and health policy, as well as further momentum for more stimulus, including additional direct payments to most Americans and funds to stabilize state and local governments’ finances. But we don’t believe many of these changes will dramatically affect valuations, except for a near-certain increase in the corporate business tax rate.
Even With Senate Control, There Are Limits to What Democrats Can Realistically Achieve
The Democrats’ sweep in Georgia opens up possibilities for them to pursue their agenda that would not be available with a divided government. However, the narrow majority will largely constrain Democrats from pursuing the more-ambitious aspects of Biden’s campaign platform, much less the more-left-wing vision on which some members of the caucus have run.
The table below shows the probabilities we assign to various initiatives given a Democratic Senate. These probabilities have some interdependency on each other. Congress can only do so much in the 2021-22 legislative session. To the extent that Congress needs to do more to respond to the coronavirus pandemic, there will be less room for other priorities.
Our baseline view is that Democrats will reverse some of the cuts in the Tax Cuts and Jobs Act and then use the money to expand Medicaid and add some incentives for consumers to reduce their greenhouse-gas emissions through buying electric vehicles, solar panels, and other substantial purchases. We believe any further stimulus would not be paid for with taxes.
Implicit in our assumptions is that senators will typically vote along party lines with few defections, leading to at least as much party cohesion as we saw from Democrats during the first legislative session during Barack Obama’s Administration and from Republicans in the 2017-18 legislative session under the Donald Trump presidency.
We assume Democrats will need to act unilaterally to accomplish most of their priorities, and, given the low levels of ticket-splitting among voters, as well as the fact that most members of Congress run on national rather than local issues these days, there is a reasonable chance they will have enough party cohesion to do so on modest healthcare reforms, increasing corporate taxes, and fiscal stimulus. All of these changes can happen without the 60 votes needed to overcome a filibuster. Climate change and energy policy will be much more difficult for a narrow Democratic majority to address.
A handful of Democratic policy priorities can be accomplished solely through executive action, and we expect a potential Biden Administration to pursue these priorities unilaterally. (We‘ll detail these executive branch possibilities in an upcoming article; they are largely unaffected by the election.)
Tax Hikes Are Likely Under Democratic Senate Control, but Not for Everyone
At the top of any Democratic agenda will be new sources of revenue. Other policy priorities require new infusions of money, and that could mean an increase in taxes for corporations and possibly high-income workers. Democrats have generally followed “pay-go” rules, meaning they will attempt to pay for new policy initiatives with new funds or spending cuts over a 10-year window. While these provisions may rely on gimmicks like deferred revenue-raisers to some extent, there are enough centrist Democrats that the caucus will insist on increasing revenue to pay for new programs.
Outside of increasing marginal tax rates on high earners, the most obvious place to raise revenue is by reversing the corporate business tax cuts that were reduced to 21% from 35% --which was the centerpiece of the 2017 Tax Cuts and Jobs Act. We think an increase to around 28% is very likely. That’s because as a candidate, Biden repeatedly said he would not increase taxes on those earning less than $400,000 annually, leaving few opportunities to raise revenue.
Democrats may also seek to increase taxes on the offshore earnings of U.S. corporations. However, it will be more difficult for Democrats to keep their caucus together to do so. Arcane tax issues are hard to explain to the public, and there are fierce lobbying interests across many industries seeking to keep these taxes low. But, to the extent that Democrats need this revenue for healthcare spending, we think there is at least a reasonable chance of them raising this money by increasing the rates on global intangible low-taxed income.
Our back-of-the-envelope math suggested that an increase in the corporate tax rate to 28% from 21% would reduce U.S. corporate aftertax earnings by an average 6%. If we also saw increased taxes on offshore earnings, that could reduce aftertax earnings by perhaps a total of 9%. Very likely, the market’s reduced expectation of corporate tax hikes following the November 2020 election contributed to the rally in U.S. equities.
We think any additional revenue Congress raises through tax increases--including from any surcharges for families with more than $400,000 in annual income--will be offset with new spending as outlined, or with tax expenditures such as an increase in the Child Tax Credit.
New Stimulus May Not Be Crucial for Economic Recovery, but Vaccine Distribution Is
Next on the priority list will be additional stimulus, despite the $900 billion-plus package Congress passed in December 2020. Unlike other policy efforts, Congress will likely suspend “pay-go” rules for further response to the pandemic. Democrats will almost certainly issue additional direct payments to make good on the $2,000 stimulus checks they promised during the campaign, which Congressional scorekeepers estimate will cost almost $464 billion. Democrats will also look hard at stabilizing the finances of state and local governments, probably around the order of $350 billion to $500 billion. While the market has traded up and down off of stimulus news, we don’t think stimulus is crucial to the U.S. economy. The development of a successful coronavirus vaccine has been far more important. Widespread deployment of a vaccine in the first half of 2021 should enable the economy to largely return to normal.
Consequently, much of the slack in the economy should be gone in the next few years. Once that’s the case, additional stimulus has little effect on real gross domestic product. As such, while more stimulus could help pull forward the recovery by stabilizing state and local government’s finances, it won’t affect the long-term trajectory of GDP and therefore isn’t a major driver of company valuations, in our view.
Healthcare May Not Change Much Under New Leadership
While Democrats have largely run on healthcare since the 2018 election cycle, they will likely make only marginal changes to the Affordable Care Act at least in terms of the effect on equity valuations, unless the Supreme Court were to invalidate the law and require a legislative fix. The Supreme Court is very unlikely to do so given the case it heard on Nov. 10 and the questions key justices asked.
Given their narrow Senate majority, Democrats are extremely unlikely to legislate a high-impact public option that would substantially affect our valuations. Democrats have primarily run on defending some of the protections in the Affordable Care Act. And while some Democrats want a “Medicare for all” universal single-payer system, their nominee and now president-elect has been clear since the primaries that he does not support these efforts. Also, such a major expansion of publicly provided healthcare would cost a lot of money--more than can be raised with the tax changes we think are viable with the narrowest of majorities.
We think it also will be hard for Democrats to even add a public option for the individual marketplace. And if they did, that marketplace covers only a fraction of the people covered by the workplace market.
We believe Democrats are much more likely to expand Medicaid coverage to include people further from the poverty line or increase the subsidy in the individual marketplaces to reduce the costs for lower-income households. Such an expansion could cost between $85 billion to $105 billion annually. Either approach would rely on the existing private insurance system, and we don’t believe it would dramatically affect valuations for most firms we cover.
It’s important to keep in mind that even if the Supreme Court strikes down the ACA, it will be on very narrow, technical questions. Specifically, the court is considering the constitutionality of a now-meaningless mandate that is no longer associated with a tax and the severability of this provision from the broader law. In the unlikely event that the court strikes down the law, Congress can fix it without changing it significantly, and we believe it will restore the full act. While there may be some political wrangling around questions of religious exemptions, there will be overwhelming pressure to restore the law.
Climate Change Action Won’t Likely Be Transformative
Addressing climate policy via a large spending bill will be more politically feasible than hard caps on emissions or other harsh regulations, we believe. But we also think the probability of major new investments in clean energy are quite low.
Given the geographic and economic makeup of the Senate, a Democratic caucus will have senators from coal-producing states and states that skew more to the political right than the country as a whole. Unless there is bipartisan momentum on climate policy--which we think is unlikely--Democrats would have needed a much larger majority to maintain enough votes for the kinds of GHG regulation that Biden floated on his campaign’s website. While there will be support for minor investments in clean energy, a major package is unlikely to garner support from Democrats hailing from Montana and West Virginia, and, without a bipartisan consensus, Democratic leaders will need those votes to advance a package.
In terms of executive action, a Biden Administration does have some scope to enact major policy changes without a Democratic Senate. A Biden Administration will likely seek to increase fuel economy standards for passenger vehicles, as well as increase renewable energy’s share of U.S. electricity generation, among other measures.
In aggregate, these policy changes don’t move the needle for our oil or natural gas price forecasts. But Biden’s plan to curb drilling on federal lands would have a modest impact on U.S. oil and gas producers with significant exposure to federal lands.
With that said, Supreme Court rulings around the power of the administrative state to regulate based on legislative directives could limit what Biden can do with the executive branch alone. Such rulings could spur Congressional action on issues such as regulating GHG emissions at later dates, as they will likely center on the current authority the executive branch has under existing laws rather than the authority Congress could grant the executive branch.