I suspect the immediate reaction to a surprise Labour victory would be a sell-off in sterling (we’ve already seen a little of that) and in equities, simply because of increased uncertainty. However, as we saw in the stock market’s response to last year’s vote to leave the EU, knee-jerk responses can be quickly reversed. So, what longer-lasting effects might a Labour government have?
For equities, one threat seems obvious - higher corporate taxes. Labour plans to eventually raise £19.4bn a year in extra corporation tax and another £6.5bn from cracking down on tax-dodging, a lot of which will come from companies. That’s a total of £25.9bn.
This is big money. It’s equivalent to just over 30 per cent of the annual earnings of the All-Share index. Does it therefore follow that share prices will fall 30 per cent?
Not at all. There are several mitigating factors here. A lot of the tax will be raised from unquoted companies: these represent half of all UK-based companies*. Another chunk will come from foreign firms operating in the UK. The higher taxes will be phased in over years – and of course Labour’s tax plans might not be fully implemented, or reversed, or companies might find ways to dodge them.
Also, of course, we must remember why Labour wants to tax companies. It’s because it wants to finance higher public spending. Some of this spending, though, will flow back to company profits in the form of higher public procurement and public sector workers spending their wages.
There is, though, another offset: tax incidence. Higher corporate taxes don’t fall wholly upon shareholders, Instead, companies respond by suppressing wages or jobs, so workers share the burden. Research by Wiji Arulampalam at the University of Warwick and Michael Devereaux and Giorgia Maffini at the University of Oxford has found that almost half of a rise in corporate taxes would in fact fall upon wages. Other estimates put the incidence even higher - which has the apparently perverse implication that companies might actually benefit from higher corporation tax if enough of the burden fall eventually on workers whilst profits rise as Labour spends those taxes.
Taking all these together, I find it unlikely that share prices should fall by more than a couple of per cent as a result of Labour’s tax plans - if that.
And the impact might be even less. So far, I’ve assumed no impact upon economic growth. But there could be one. Oxford University’s Simon Wren Lewis says Labour would increase economic growth, partly because it would run a looser fiscal policy, partly because it would permit more immigration than the Conservatives, and perhaps because there would be less chance of a damaging no-deal over Brexit. This should increase corporate earnings.
You might object here that other Labour policies, such as increased top taxes and greater statist regulation, would weaken growth. I’m not so sure. We know that Nigel Lawson’s cut in top tax rates did not lead to faster growth, so why should their partial reversal depress growth? It might well be that – Brexit excepted! - trend growth is largely unaffected by government policy, for good or ill – as Dietz Vollrath and John Landon-Lane and Peter Robertson have shown. (one reason for this is that policies that would depress growth are often either abandoned or not implemented at all).
Though governments can’t much affect trend growth, they can affect cyclical growth via fiscal policy. This might be just what Labour would do.
Which brings me to sterling. While increased uncertainty might depress the pound, elementary economics tells us that there’s one route through which Labour should strengthen it.
Looser fiscal policy implies higher future interest rates, relative to what we’d get under the Conservatives. This is not because the gilt market would panic about higher government debt. It’s simply the normal effect of expectations of higher future growth because of a fiscal expansion: it’s the standard Mundell-Fleming textbook model which generations of students have learned. This is a feature, not a bug. The argument for looser fiscal policy is precisely that it would get us away from zero interest rates and so give the Bank of England room to cut rates when the next downturn comes.
The question is: what might offset this mechanism for a stronger pound? Short-term uncertainty is one factor. And there might be an element of incipient capital flight as companies and top earners think of ways of hiding their wealth from the tax man. On balance, though, I find it hard to believe a Labour government would cause a sustained drop in sterling. Given the huge proportion of corporate earnings that come from overseas, this is not necessarily welcome for equity investors.
On top of this, some Labour policies would hurt specific companies. Its financial transactions tax (stamp duty on derivatives) would hurt a few financial companies, more by closing off marginally profitable activities than by clobbering them with a high tax bill. And a ban on zero hours contracts and a higher living wage would squeeze some firms’ profits - though most of these would be small unquoted companies. Offsetting these, though, would be construction firms (among others) that would benefit from greater spending on infrastructure and housing.
Overall, I suspect the net impact upon equities of a Labour government would be slight. Three considerations reinforce this view.
First, stock markets are globalized. If overseas markets continue to do well, UK equities would follow. Equally, a global bear market would hurt UK stocks hard even under the most finance-friendly of governments.
Secondly, it’s easy to confuse one’s own personal interests with the nation’s interest: psychologists call this the false consensus effect. This leads top earners to exaggerate the overall damage Labour’s policies would do.
Thirdly, politicians, and people who are interested in politics, tend to exaggerate the importance of party politics – just as perhaps economists exaggerate the importance of economics in our lives. This leads to over-estimates of the effects of conscious policy actions and to under-estimates of the role of impersonal emergent processes.
It is, though, the latter that set the climate for investors. If the emergent processes that have given us secular stagnation continue the climate will be challenging and risky for equity investors whoever is in office. One thing to be said for Labour is that it is less unaware than other parties of the need to respond to that stagnation.
Overall, then, any significant sell-off of equities in the (still-unlikely) event of a Labour government would probably be a good buying opportunity.
* Official figures show that at the end of 2016 UK companies’ liabilities comprised £1.97 trillion of listed shares and £1.79 trillion of unlisted ones (tables 3.1.9 and 4.1.9 here).
