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Brian Andrew, CFA

To Cut Or Not To Cut

Last week Wednesday, the “Tax Reform” (subtitled: Unified Framework for Fixing Our Broken Tax Code) plan put forth by Republicans in the House was released and critiqued by politicians from both parties. While there are many unanswered questions about the final details, there are a number of items that seem favorable for the economy and stock investors. The plan was hailed as a “growth” plan by the administration, and the rally in stock prices seemed to suggest investors’ agreement. However, as the details are hammered out, we’ll see if the “reform” becomes a cut only and just how big the cut may be.

Corporate Taxes

One of the main provisions of the plan is to reduce the top corporate tax rate from 35% to 20%. This rate is closer to the average of other developed countries around the world. As an example, the average corporate tax rate for the largest 100 companies in the U.S. is 18%. In other words, because they are global, they have the ability to do business wherever they’d like and take advantage of lower global tax rates. The proposed reduction in the corporate tax rate will benefit small companies who don’t share the same global benefit. Among small companies, the average tax rate is over 30%, so it would seem the reduction could give them more capital for reinvestment, thereby creating economic growth. The cost of this provision is $1.5 trillion over 10 years.

The rally in small company stocks since the plan’s issuance seems to suggest that stock investors agree on the benefits of this type of tax reduction.

To pay for this, there is a proposition to limit the interest rate deduction and a number of other corporate deductions which would raise revenue by $1.450 trillion over the same period.

The other provision in the reform plan is the reduction in the top rate for privately owned companies such as those organized as “Sub-S” companies. Bear in mind that more than half of U.S. workers work for companies with fewer than 1,000 employees, so this type of provision would reduce the taxes paid by small companies. They would benefit from increased retained earnings which would likely lead to greater business investment and consumption. Isn’t that just a tax cut for wealthy people, some ask? It may be that some business owners are wealthy; however, this type of rate cap would aid many plumbers, restaurant owners and contractors. The rally in stock prices benefits anyone with a pension plan or 401(k).

According to the plan, there is approximately $2.4 trillion in corporate cuts and $1.7 trillion in revenue additions for a net cost to taxpayers of $725 billion over 10 years. (The economy is currently almost $19 trillion annually and the Federal budget is almost $5 trillion per annum.)

Individual Taxes

Looking at the reform aspect of the plan for individuals, the primary change is the reduction in the number of tax brackets to three or four. This consolidation cannot be scored just yet, because the plan doesn’t include details about how the income limit for the brackets will come into play. While many have already excoriated the plan for its cost to low income earners or cuts for the wealthy, we really don’t have enough details to do the math on who benefits.

The proposed plan would reduce total tax revenues from individuals by approximately $2 trillion. However, the elimination of the state and local tax deduction would raise $1 trillion. Looking at the other changes, which include eliminating the personal tax credit in favor of a larger credit for individual and married filers, the cost of the reform plan for individuals could be as much as $2.1 trillion.

Any reduction in the taxes individuals pay results in higher consumption. Because nearly 70% of the economy is driven by the consumer, this would result in faster economic growth.

A Long Way from Passing

Still, we are a long way from the finish line. There are many other provisions in the tax reform plan that seem to have little likelihood of passing. Two of these are the elimination of the estate and alternative minimum taxes. These have a high cost and wouldn’t be offset by any additional revenue, and there doesn’t seem to be much chance that they will remain included.

While many worry about the thin margin Republicans enjoy in the Senate, they should recall the divisive nature of that party during the health care debate. Fiscal conservatives in the Republican Party will be tougher than some Democrats when it comes to the details of the plan.

The Senate passed a budget resolution on Friday which gets the ball rolling. However, as compared to tax plans during the Reagan, Clinton and Bush administrations, we are behind. Each of those plans was tackled at the beginning of each respective administration, with plans/resolutions offered and passed by June. Here we are in October and just getting started.

This means that any plan is likely to be a 2018 event. Current projections show that if the plan were passed during the first quarter of 2018, it may add as much as .25% to economic growth. The stock market may continue to price in the corporate tax reduction benefits between now and the plan’s passing as long as rhetoric makes it seem likely that it can actually pass. You may recall we had a similar effect at the end of 2016, and that euphoria faded as Republicans and the administration took up health care first. Because they are 0 for 3 in getting health care reform passed, they don’t have the proposed $900 billion in savings from that effort, which suggests the tax reform plan will become a more modest tax cut and less about meaningful reform.

There is no question that reducing the tax burden for individuals and corporations is beneficial to the economy and its trajectory of growth. Any sort of reduction in tax burden next year is likely to allow this old economic recovery (soon going on year 10) to continue leaving stock investors with the benefit of continued earnings growth into 2018.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.