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A Foolish Take: Tax Cuts and Stock Prices

The CEO of a major regional bank recently told me something interesting about the prospective tax reform making its way through Congress. If a tax reform bill passes, he believes it will give the economy two or three more years of expansion.

This makes sense given that taxes are simply an expense, weighing directly on a company's bottom line. Because earnings drive stock prices, moreover, it also makes sense that tax cuts would be good for stocks.

Data source: Yahoo! Finance. Chart by author.

However, if a tax package doesn't pass, then the economic expansion we've seen since the end of the financial crisis might stall out, much like an airplane does when it climbs too far, too fast.

If this were to happen, stock prices would almost certainly suffer. The S&P 500 is up 24% since just before last year's election on hopes that tax and regulatory relief will increase corporate profits. If the tax reform bill doesn't pass, these gains could evaporate.

Moreover, the Federal Reserve doesn't have much ammunition to combat either a recession or a steep drop in the stock market. Ordinarily when that happens, the Fed reduces interest rates. But with short-term rates still low, dropping them further won't serve as much of a stimulant.

This could be why the head of JPMorgan Chase's investment bank recently predicted that a steep stock market correction could occur in the near future.

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John Maxfield has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.