A retail investor’s guide to the Inflation Reduction Act: how to prep your portfolio

how to, a retail investor’s guide to the inflation reduction act: how to prep your portfolio

A retail investor’s guide to the Inflation Reduction Act: how to prep your portfolio

If investors thought they were getting their legs in a volatile stock market, a new tax, climate and healthcare spending bill from Capitol Hill might have them trying again find their footing.

The Inflation Reduction Act’s 1% stock buyback tax, 15% corporate minimum tax and big hopes for the green energy industry all have potential ripple effects for retail investors, experts say.

If the bill becomes law, investors may quickly spot some related outcomes. Look at the pop for solar power companies, electric vehicle makers and fuel cell companies on Monday, a day after Senate Democrats eked the bill through on a 51-50 vote.

Other results may be tougher to see, like the potential bottom line drag for a minimum 15% corporate tax.

The corporate tax floor and the 1% stock buyback would have a “minimal impact” on earnings expectations, a Citi note said Monday. More Federal Reserve interest rate hikes, inflation’s toll and potential economic slowdowns are still the bigger story, Citi analysts noted.

Still, it’s worth knowing the bill’s implications considering its rosy chances for passage.

The Inflation Reduction Act — a label Republicans fiercely question — now heads to the Democrat-majority House of Representatives where a vote could happen Friday. President Joe Biden says he supports the bill.

After markets saw a strong July trying to rebound from a bearish start to 2022, August is starting with a rough patch. The S&P 500 lost ground for the fourth straight trading day Tuesday, while the Dow Jones Industrial Average and the Nasdaq Composite were also down, awaiting Wednesday’s latest read on inflation.

The Inflation Reduction Act’s 1% tax on stock buybacks

Companies reward shareholders through stock buybacks and by paying dividends. The tax code treats the two outcomes differently. The investor who gets qualified or ordinary dividends has to pay taxes on the income. On qualified dividends, it would be a 15% tax that year for many people. That is, unless they own the stock in a tax-deferred account like a 401(k).

It’s more complicated, and politically fraught, for stock buybacks.

When companies repurchase their equity, that can push the share price higher for the outstanding shares — and critics say buybacks are an unfair move that have become increasingly popular.

For stockholders, there’s no tax event on the higher-priced shares until they sell and pay capital gains tax. If the shares are later inherited and the new owner eventually sells, they can bypass plenty of potential tax through the “step up in basis” that re-pegs the starting basis for capital gains taxes.

Enter the new legislation’s stock buyback tax, which taxes corporations 1% on the value of the repurchased shares.

“Imposing a small 1% buyback tax is a reasonable way to offset some of the tax advantage,” compared to dividend payouts, said Thornton Matheson, senior fellow at the Tax Policy Center. Still, Matheson noted, “it’s really the shareholder who will bear the burden.”

That could happen two ways, she explained. It might nudge corporations to issue more dividends instead of buybacks, which would keep the tax bill with investors. Or if companies proceed with a buyback, the repurchased amount is 99% of what it would have been because now companies need to pay the 1% cut for taxes, Matheson noted.

The 1% tax would apply to buybacks starting Jan. 1, 2023.

But is a 1% tax enough to shift companies away from buybacks toward more dividends? Douglas Feldman has doubts.

“For everyday investors that are worried about how this tax is going to impact them, I think maybe on the margins, maybe, a 1% tax is going to slow down some share repurchases. But I’m not sure that’s a major thing,” said Feldman, chief investment officer at Stash, a banking and investment app aimed at newer investors.

A “far greater driver of stock market performance in the near and medium terms” include interest rates, inflation and economic conditions, Feldman said, echoing Citi analysts. “I don’t think 1% of tax is large enough to either stop buybacks or to shift from buybacks to dividends.”

Understanding the Inflation Reduction Act’s 15% corporate minimum tax

On paper, the corporate income tax rate is 21%. But critics, including Biden, have long said companies use the tax code’s thicket of rules and write-offs to shrink their tax bill far below that.

As a result, at least 55 major corporations paid no corporate income tax in 2020, said researchers at the left-leaning Institute on Taxation and Economic Policy after they reviewed publicly-available financial disclosures.

For Democrats, the backstop is an alternate 15% minimum tax on the “book income” of a corporation with at least $1 billion in profits over a three-year average.

Book income is what’s in the financial statements that companies produce for the investing public to see and scrutinize. Book income can vary from taxable income due to the different reporting standards for each.

That’s one part of the trouble potentially laying ahead, said Will McBride, vice president of federal tax and economic policy, at the right-leaning Tax Foundation. The $1 billion threshold could give companies a strong incentive to tweak and adjust their reporting on costs and profits in order to avoid or minimize exposure to the tax.

“Diminishing the value of their financial statements is going to be very costly” for the investors, big and small, who are trying to make investing decisions based on financial statements, McBride said. The added complexity may also end with uneven results, hitting some sectors harder than others.

“Companies have some degree of flexibility in reporting items of income and expense, and in as much it affects their book tax liability, companies may respond by altering the information reported on their financial statements,” he said. “Studies indicate that is what companies did the last time a tax like this was levied in the late 1980s.”

As the bill started wending through Congress last month, the American Institute of CPAs told lawmakers the minimum tax “violates numerous elements of good tax policy and may result in unintended consequences that must be carefully considered.”

The organization went on to say “public policy taxation goals should not have a role in influencing accounting standards or the resulting financial reporting.”

Any dent on stock prices would be slight, according to a UBS note Monday. “The taxes would have a very minimal 1% drag on S&P 500 earnings per share, though some companies will be more affected than others,” the note said.

That’s near Goldman Sachs estimates, which said the minimum tax and buybacks would decrease S&P 500 earnings per share by 1.5% on the whole, but the declines could be deeper in sectors such as healthcare and information technology, which operate within lower effective tax rates.

Advanced Micro Devices Nvidia and Ford were some of the 102 companies that could be candidates for more taxes, according to a UBS strategist review.

Could the Inflation Reduction Act’s green energy focus grow an investment portfolio?

On Monday, companies and ETFs within the clean energy sector jumped after Senate passage on a bill stuffed with many generous tax credits for homeowners and car buyers. Do the $369 billion in climate and energy provisions translate to investment opportunities?

Perhaps — but the usual dose of investing caution applies, said Feldman. Some of the bill’s winners are companies in the green energy sector, he said. It’s not necessarily a winning bet for investors to single out particular companies for stock purchases. That’s why people may want to consider ETF exposure to the whole sector instead, he said.

More than one-third of participants (35%) for a Stash survey on Americans’ financial situations said they would invest in companies engaged in global sustainability if they had more money, Feldman noted.

Money has recently been pouring into clean energy ETFs, said Aniket Ullal, head of ETF Data & Analytics at CFRA, a global investment research firm. Since Sen. Joe Manchin, a centrist Democrat from West Virginia, initially struck a deal on the bill in late July, Ullal noted the Invesco Solar ETF raked in $283 million in new inflows and climbed 16%. The iShares Global Clean Energy ETF ICLN has taken in $22 million and climbed 17.5%, he said.

As the bill gets closer to law, it’s giving investors a glimpse on the parameters and incentives that could shape the green energy industry, said Stacey Morris, head of energy research at VettaFi, an ETF data and analytics research firm. “There’s just a better sense of what the playing field is going to be going forward,” she said.

If the bill becomes law, “we expect to see continued retail interest in both types of clean energy ETFs, but particularly ETFs like ICLN and TAN that hold ‘pure play’ alternative stocks,” Ullal said.

It may still be tricky for people to pinpoint individual winning companies considering the complex regulations to follow, like on domestic sourcing, Morris noted. “I think investors need to be cognizant of some of those details before jumping in with both feet,” Morris said.

Lawmakers can set aside money for the sector, but that will not guarantee generous company returns. “There’s still an element of execution on these companies even though the government has made the path easier for them,” Morris said.

Hear from Ray Dalio at the Best New Ideas in Money Festival on Sept. 21 and Sept. 22 in New York. The hedge-fund pioneer has strong views on where the economy is headed. 

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