November 8, 2017— There is no single issue that has been discussed more since the November 2016 presidential election than tax reform. This is particularly true within investment circles, though sentiment regarding likelihood of passage has ebbed and flowed throughout this year. Last Thursday the House Republicans released the Tax Cuts and Jobs Act, a bill that would cut taxes by about $900 billion for individuals and almost $600 billion for companies. Static scoring (i.e., giving no consideration to possible growth effects of the tax cuts) pegs the cost at around $1.5 trillion over the next 10 years. The 429 pages of legislation proposed by the House include many provisions that aim to provide tax relief to individuals and corporations, while simplifying the tax code (though for most of us, there never has been nor ever will be anything “simple” about taxes). Here we break down what to expect as the process progresses, what we view as the key market-moving proposals, and how much of tax reform is already priced into the markets.
Proposed amendments and heated debate among lobbyists and House representatives began this week, and will likely continue until Thanksgiving when Speaker Paul Ryan is expected to bring the bill to the floor for a simple “yes” or “no” vote. The Senate is concurrently wrapping up its initial version of a bill to be released in the coming days, although its version is expected to look different from that of the House, which would likely then lead to a conferencing of the bills between the two chambers. In other words, any final legislation that manages to make it to the president’s desk is likely to look different (perhaps significantly) from the current House bill. As investors, we are cautious to jump to conclusions at this point.
Key issues for investors
With that in mind, we expect investors, ourselves included, to be closely watching several key issues likely to remain at the forefront of tax debates. These are not the only important issues, but perhaps the ones with the broadest implications for markets:
- Immediate vs. phase-in of tax cuts—Whether to adjust tax rates immediately or phase in changes over a series of years is a consideration that has arisen historically in many pieces of tax legislation. Obviously, an immediate tax cut would be more costly than a phased-in approach over the same time period. Members of the House Ways and Means Committee floated the idea of a phased-in cut last week but ultimately decided to include an immediate cut in their bill. The cost-saving measures of a phased-in tax cut may be more appealing in the Senate, where the budgetary impact must be deficit neutral over the budget window (i.e., 10 years) for the tax changes to be permanent. However, the market may be underwhelmed by a gradual tax cut over five or ten years, in part due to the more restrained growth impact expected in those first few years. Most individuals are incentivized by the rate of change in their disposable income, and a gradual tax cut could lead to a more muted demand response. A middle ground may be a less dramatic but immediate tax cut.
- Corporate expensing and interest deduction—These measures affecting the corporate side of the tax code are often paired. In our view, 100% immediate expensing of capital equipment and expenditures could be one of the most impactful aspects of tax legislation. Currently, companies can expense 50% of the cost of equipment up front, but the other 50% must be depreciated over a number of years, meaning companies must wait a long time before recouping the cost of their investment. Capital investment has been anemic during this recovery and has only begun to increase this year (Figure 1). A resurgence of capital expenditures could not only be a tailwind for industrial companies but also boost productivity more broadly. The House’s proposed revenue offset to expensing is to limit interest deductions to 30% of earnings, a move that would attempt to place debt and equity on an equal playing field in a company’s financing decision, but could hurt companies with high debt levels across a number of industries.
Capital Goods New Orders ex-Defense and Aircraft (year-over-year %)
As of September 30, 2017
Source: Source: Bloomberg, U.S. Census Bureau
- Dynamic scoring—Dynamic scoring refers to a rule that would allow estimates of the growth impact of tax changes to be included in the forecast for the budget impact. This is particularly important, as the Senate has a strict rule to prevent budget-related bills passed through the Budget Reconciliation process (only requiring a simple majority of 51 votes in the Senate) to be permanent if they increase the deficit over the budget window. Growth estimates from tax bills are notoriously difficult to calculate and inherently flawed. However, a bill using dynamic rather than static scoring would cost less and give the Senate a better chance of passing permanent reform. It is unclear whether the Senate Parliamentarian will allow dynamic scoring. In our view, permanence of the legislation makes a material difference to economic growth, company earnings estimates, and the stock market. To be fair, the market would probably reward a temporary tax cut, as markets tend to reflect information over a relatively short horizon. But companies looking to make long-term investment decisions will be less likely to significantly alter or relocate operations if the tax benefits of doing so expire after 10 years.
The BAT is back?
One aspect of the House bill that deserves attention is the treatment of foreign earnings. This area of the tax code is particularly complex, and the House bill aims to remove companies’ incentives to relocate operations or legal domicile overseas. One specific proposal addressing this is the mandatory repatriation of capital at a lower rate. This would result in an initial hit to companies with significant cash overseas, but if cash is brought back to the U.S. it could be used to fund capital investment, stock buybacks, or dividends—all positives for investors of U.S. equities. U.S. companies in aggregate are estimated to have about $3 trillion parked overseas, a significant amount of capital even if only a portion reverts to U.S. soil.
The more hotly debated issue is around a tax proposed by the House that would have companies pay tax on profits earned by their foreign affiliates. Current law does not tax profits earned by subsidiaries unless those earnings are brought back to the U.S. The House is proposing taxing subsidiaries as if they are U.S. companies, or if the company does not want to subject their subsidiaries to the U.S. tax code, requiring U.S. companies to pay a 20% excise tax on imports of goods or intellectual capital from those companies. Some are comparing this to the Border Adjustment Tax (BAT) proposed by the House in its 2016 blueprint—a proposal that was likened to a tariff and met with an uproar from international lobbyists, consumer advocates, and even U.S. corporate magnates, like the Koch brothers. We expect much debate in coming weeks, as this could hurt companies in the pharmaceutical, technology, and retail industries, all of which have large and functioning lobby groups. While it is noble for the House to attempt dramatic steps to reform the international tax code, it is more difficult to garner sufficient support along party lines to achieve true reform, as opposed to merely simple tax cuts.
What’s priced in?
It is not an easy exercise to determine the degree to which stock prices already reflect the impacts of proposed tax reform (i.e., how much tax reform has been “priced in” by markets). In our view, failure to achieve any sort of tax legislation would be a disappointment to markets and could see stocks pull back. However, we also do not think tax reform is fully priced in. We follow the relationship between companies that have a high effective tax rate and those with a low effective tax rate. (When high-tax companies outperform as a group, it could signify greater optimism for tax reform by investors.) This year has seen companies paying a lower effective rate outperform their higher-taxed counterparts, indicating a deterioration of investor sentiment related to taxes since the election. Even small-cap stocks—which stand to benefit more from tax reform since they generally utilize fewer deductions and pay a higher effective tax rate than large caps, of about 30% vs. 25%—enjoyed a post-election rally but then lost ground relative to their larger counterparts, as failure to pass healthcare legislation exposed the challenges of passing substantive legislation. Over the past few weeks, as progress was made on tax legislation, small caps have outperformed (Figure 2). We see these data points as signaling that, in 2017, the U.S. stock market has been driven more by earnings growth (and possibly regulatory relief) than anticipation of tax reform. Analyst estimates for the impact of tax legislation on the S&P 500 index range from a 5%–10% earnings boost, with small cap stocks to benefit even more.
U.S. small caps relative to large caps
As of 11/7/2017. Reflects the performance of the Russell 2000 Index relative to the Russell 1000 Index, indexed to 1 on November 7, 2016.
In our view, betting on Washington is a risky proposition. Our neutral positioning to U.S. equities large and small is based on a view that the U.S. is in the later stages of the economic cycle but is still reflecting solid growth. Tax cuts would allow our clients’ portfolios to benefit from a full weight to U.S. equities (about 40% of a fully diversified portfolio of moderate risk) without assuming undue risk from current valuations and other late-cycle indicators. We are also underweight fixed income, as we expect interest rates to increase and the curve to flatten even without tax legislation. Tax cuts that boost growth, inflation, and/or long term deficits could see rates at the long end of the curve rise and the curve steepen. The tax reform process is extremely fluid, and we are monitoring developments in Washington, as well as broader economic signals, to adjust portfolios as necessary.
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