What Does the Tax Proposal Mean for the Markets?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 28, 2017 3:09:05 PM

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tax proposalThe big economic news today is the tax reform proposal that the Trump administration unveiled yesterday. For once, we have a proposal that really does live up to the hype. If passed (a big assumption!), this would be the most consequential revamp of the tax system since 1986 in the Reagan administration.

But to figure out the likely effects on the markets, we need to first understand not only what the proposal says and who it would affect, but also whether—given those effects—it is likely to pass.

What does it say?

From an investor’s perspective, there are five big takeaways of the tax proposal: three good and two less so. Let’s start with the good ones. First, the corporate tax rate would be cut from 35 percent to 20 percent. Second, it would allow for immediate expensing of business equipment investment. Third, it proposes tax-free repatriation of foreign profits in the future. The two “less good” points are that it limits the deductability of interest payments and calls for a one-time tax on stockpiled foreign profits.

A lower tax rate. Of the good ones, this seems like an unqualified benefit to companies. And it is—although less so than it may seem. The headline rate of 35 percent is one that few, if any, pay. The effective rate is estimated to be in the mid-20s, which means the 20-percent face rate will indeed be a cut, just not a very big one. Nonetheless, this will be a benefit. Companies will be able to drop a number of costly tax-avoidance strategies and focus more on their core businesses. This will help both the bottom line and operating costs.

Immediate expensing of business investment. Again, this is an unqualified good, allowing companies to invest in the business and recover the costs immediately from a tax standpoint. It could also be positive for the economy as a whole. Specifically, economic growth and productivity—two areas that could certainly do with the help—would likely increase. Both of these would help all businesses, but in some respects would actually be better for smaller companies than large ones, which again is a positive feature.

Tax-free repatriation of foreign profits. This will be a positive aspect in terms of company earnings. Here, though, the benefit is likely to go primarily to larger companies and those focused on exports. As such, the benefit will be narrower and less additive to the economy as a whole.

One-time tax on stockpiled foreign profits. The effects of this item are less clear. Depending on how large, the foreign profits tax would take a bite out of those stockpiled assets. But to the extent some taxation was inevitable, it will probably not have a large effect.

Limiting the deductability of interest. Here, there is potential for a very large effect. Many companies carry large amounts of debt specifically for the tax benefit, and many have been issuing debt to buy back shares for the same reason. So, this could well result in substantial corporate restructuring. Heavily indebted companies would potentially face much higher tax bills, at least until they de-levered. But it’s important to note that the proposal is unclear about what “limited” might mean, so we can’t really estimate any effects until we see what Congress does. This is, however, an area of concern.

From a business standpoint, all this stuff is generally positive. On the individual side, the benefits are less clear cut, and the costs clearer. Notably, by eliminating many deductions, the effect on individual taxpayers will vary significantly depending on their situation.

Political headwinds

What is clear, on both the individual and business sides, is that the elimination of many deductions will create political headwinds. Past attempts at tax reform have largely been blown away by those headwinds, and we can already see a couple from the proposal as is. Most notable, in my opinion, is the elimination of individual deductions for state and local taxes paid. Anyone who lives in a high-tax state (e.g., California or much of the Northeast) will face a tax hike from this. That alone may lose the votes of many members of Congress from those states, even among Republicans, and will certainly make it a harder sell to Democrats.

The other major headwind to passage will be the effect of the proposal on the deficit, which is not mentioned at all. Past tax cuts have increased the deficit. With the Republicans publicly committed to fiscal rectitude, this is another potential headwind. Against these very real negatives, however, is the fact that the Republicans, who control Congress, have a real political need to succeed here, which might overrule all of the negatives.

The initial market reaction . . .

For markets, the initial reaction seems to be positive. Although it is early days, the possibility of the positives seems to have moved markets up a bit. Should there be actual progress in passing the proposal? Expect more upside. The fact that tax reform has moved into an actual proposal—and a good one from a business perspective—suggests that something good might well come out of it. Indeed, this would help keep the markets moving upward.

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