Now that it appears likely that the new Tax Plan will be passed into law, I thought you might be interested in a brief note as to some of its implications.
As you know, the final bill is still coming together through the reconciliation process but, at this point, we have a fairly concrete view as to the major points of the plan. The plan will make some major changes to both corporate as well as individual tax codes. In the end, tax rates will be lowered, government debt will rise and economic growth should also pick up (albeit unlikely enough to offset the increase in government debt levels).
Let’s take a look at some of the broad implications:
Generally speaking, corporate tax rates will drop to 20% (or possibly 22%) and some corporate interest deductibility will be removed. The end result will be that corporate earnings will rise. In fact, it is likely that earnings, as measured by the S&P 500, will rise by 5%-10%. Improved corporate profitability will likely translate to some business reinvestment which should produce some benefits to economic growth. In highly competitive industries, some companies may also use their improved margins to compete on price thus consumers may benefit from slower inflation (in certain industries).
Another important change in the corporate tax code is a favorable tax rate to repatriate cash that is held overseas (and to reduce the future incentive to shield overseas profits). This change should prompt $1-2 trillion dollars to return to the United States. While some suggest that this will spur U.S. growth dramatically, this point of view is likely farfetched. Generally speaking, the companies that have huge amounts of cash overseas are technology and pharmaceutical companies. Most of these companies are not cash constrained. If they previously wanted to invest in the United States, they could have easily done so. That said, we might see some token investments that will probably be more about PR than business. While the repatriation tax changes may not produce a dramatic increase to U.S. economic growth, the influx of cash will likely produce increased shareholder dividends, stock buybacks and merger activity which has positive connotations for the equity market.
On the individual side, the changes to the code are much more mixed. There will certainly be some big winners and some big losers. The most important positive changes are the large increase in the standard deduction as well as lower tax rates across the board coupled with a change in tax brackets. However the offsets in the code will impact some individuals to such an extent as to substantially raise taxes paid. Specifically, the deductibility of state and local taxes (including property taxes) will likely be limited to $10,000. This means that if you are in a high income tax state and/or have high property taxes, you will not be thrilled by the tax changes. The unintended (or maybe intended…) consequences of these changes may end up having some long-term ramifications on the economic health of higher tax states which could see a diminution of their tax base as residents slowly move to lower tax states creating a vicious cycle – but that is for another conversation. One final caveat, depending on how the reconciliation goes, the change in individual tax rates may expire around 2026.
As highlighted earlier, U.S. economic growth should see a benefit from the various tax changes. Whether that is to spur growth by 0.3%, 0.7% or 1.0% will be determined. That said, it is very difficult to find an economist who expects that the boost to economic growth will be enough to offset the cost of the program. The true impact is really not quantifiable at this time. We will just have to see how it goes.
U.S. Equity Markets
U.S. equity markets should be a clear winner from the tax code changes. As we already highlighted, the repatriation tax code change should spur dividend increases, stock buybacks and merger activity which are all supportive to the markets. Even more significant is the 5%-10% rise in corporate earnings from lower tax rates. As we have discussed many times in the past, U.S. equity markets have been trading at a valuation that is a little higher than ideal. Currently, the S&P 500 trades at a Price Earnings Ratio (P/E) of 20.2x. This is above the typical range over the last 25 years of 14x-18x in “normal” times. Accounting for the expected rise in earnings from the tax cuts, the P/E ratio would fall to approximately 18.8x. While a little above ideal the valuation would be acceptable given expected earnings growth in 2018 (separate from the tax impact).
You will note that I have not made any comments about the removal of the healthcare individual mandate or made any other social commentary. The purpose of the note was to focus strictly on the economic and market ramifications of the plan. We will see what comes out of the reconciliation process but, for now, I wanted to give you a brief rundown of the various impacts.