Republicans in Congress, and the president, have been describing the benefits of the tax bill in terms of an “average family of four” and then quoting the benefit that family will receive in reduced taxes in 2018. While it may be necessary in our short attention span, 24/7 news cycle to come up with soundbites that attract attention, we wonder who that family is. The 500-page tax bill is complex, and who benefits can’t be boiled down into a single tweet or sentence. Our weekly commentary affords us the advantage of several hundred words, so we’ll try to provide some clarity on how the tax legislation will impact the economy, markets and taxpayers.
The Senate passed the tax bill Tuesday and then sent it back to the House, which also approved it a second time, with 12 Republicans dissenting and no Democrats voting in favor of it. As the bill makes its way to the president’s desk, we can begin to assess its impact. The market had begun to anticipate the conclusion of the tax debate and the passing of a bill before year-end. The Standard & Poors 500 Index has been up as much as 1.7% this month.
It is important to keep in mind that this tax plan passed in the House without a single Democrat voting for it. The same is true in the Senate. Much like what happened with the Affordable Care Act, this means that if Democrats took control of Congress in the 2018 mid-term elections (the president’s party has lost Congressional seats in every mid-term election but two since 1934), they could try to repeal all or portions of this tax bill. When there is no partisan compromise, it is hard to make long-term policy changes that stick. This sets up mid-term elections as being an important risk factor for 2019.
One of the bill’s hallmarks is the reduction in the corporate tax rate from 35% to 21%. Many have noted that corporations already pay less than the current 35% tax rate, and while it’s true that some pay less than 20%, many pay the full 35%. The cost of this provision is expected to be nearly $1.35 trillion over 10 years, suggesting that it is a real benefit for many. The tax reduction is partially paid for with the elimination or reduction in expenses that can no longer be written off. For example, limiting how much interest expense companies can deduct to no more than 30% of their adjusted taxable income raises $253 billion over ten years. There are also more esoteric changes, like the elimination of deductions for the cost of college athletic event seating will raise $2 billion. Because of the number of tax law changes needed to pay for some portion of the rate cut, companies will be affected differently.
Not every company will benefit. Wednesday, an analyst report from Deutsche Bank suggested that GE has done such a good job avoiding taxes under the old rules (their estimated tax rate this year is 5%), they will see a significant tax hike under the new rules. The analyst notes that they have $82 billion invested overseas, and the mandatory repatriation of some of that cash could cost them an average of $1.1 billion per year in additional tax over the next eight years. We make this point to suggest that the complexity of the tax changes will require a company by company analysis that will ultimately result in a variation of who benefits from the reform. In addition, some industries will be better off than others. As we look forward to 2018, we will perform this analysis to determine if our portfolio positioning should change.
There is no doubt that the tax impact will be beneficial to corporate earnings. Most analysts estimate that the reduction in the corporate tax rate alone will add $8 to $10 to the S&P 500 Index’s earnings next year, raising next year’s estimate by more than 6%. Using a 19 earnings multiple, this would add 152 to 190 index points. However, we must assume that some of this has already happened. In fact, stocks sold off slightly Wednesday on news of the bill’s passage through the House and Senate.
Determining the effect that the reduction in corporate tax rates may have on economic growth will take more time. Business confidence is high and capital investment is already rising. It remains to be seen whether or not the rate reduction speeds up that process, thereby creating faster economic growth. In any case, we will likely see higher estimates for economic growth next year as a result of Tuesday’s action.
There is considerably more debate about how the new tax legislation affects people with different levels of income. We believe the bottom line is this, there is a $1.214 trillion reduction in individual income taxes over the next 10 years. If the economy is roughly $19 trillion in size, and that income becomes consumption, than we should see approximately .65% more consumption growth in 2018. This will almost certainly also add to economic growth which is why, as mentioned earlier, growth forecasts will be higher.
Of course $1 saved in taxes doesn’t automatically become $1 spent. So the estimate and reality may be different. There is savings to consider as well as the rate of inflation which increases prices and eats into the tax cut. Also, how the individual tax cut is paid for will impact consumption.
The repeal of certain itemized deductions and institution of caps such as the $10,000 cap on the deduction for state and local taxes, raises $668 billion to pay for the individual tax cuts. For some high income earners this could mean that they actually receive a tax hike if they live in high taxed states (Not a bad thing in our view as the previous system allowed high tax states to receive a larger federal benefit as the deduction subsidized their higher taxes with lower federal tax).
The repeal of the Affordable Care Act mandate also is expected to raise $314 billion. Because this was a lynchpin to the ACA, any change in Congressional leadership in 2019 will almost certainly put this issue front and center. As mentioned earlier, this is the problem with partisan driven policy making.