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Tax Reform: The Home Stretch

Tax Reform: The Home Stretch

Tax reform legislation has now passed both chambers of Congress and looks very likely to become law by year-end. While the final tax bill will undoubtedly look quite different from what has been proposed in both the House and the Senate, the key question for investors is who stands to benefit the most, or the least, from the proposed reforms.According to experts, the current tax reform plan would result in roughly $5 trillion in tax cuts over the next 10 years.  Below are the tax reform highlights that everyday investors need to focus on:

  • A reduction in the corporate tax rate from 35% to 20%; The headline corporate tax rate in the United States currently stands at 35%, but the effective corporate tax rate of S&P 500 companies – in other words, the tax rate that they actually pay when all is said and done – is lower, at around 25.6%. Furthermore, as shown in the chart below, there is significant dispersion across S&P 500 sectors when it comes to the effective tax rates. On the one hand, REITs do not pay taxes at the corporate level, and the dividends that investors receive are taxed at their individual tax rate. Meanwhile, technology companies have set up operations around the world in an effort to pay the lowest tax rates possible, while telecommunications companies have the highest effective tax rate of all the sectors in the S&P 500. When it comes to taxes, not all sectors are created equal.

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Source: JP Morgan    

The one thing that we can all agree on is that lower corporate taxes result in higher corporate earnings.   Lowering the corporate tax rate from 35% to 20% would be a boom for most companies in the S&P 500 Index (especially the sectors north of the average). Goldman Sachs’ investment bank predicts that the tax reform could add an additional 12% to earnings per share for the S&P 500 index in 2018 or 2019 (depending on the final bill). Under these estimates, the current forward price to earnings ratio of the S&P 500 index would fall from 18.0x to 16.6x.   Given that most analysts can agree that U.S. Stocks have been overvalued for years, this increase in earnings (and decrease in stock valuations) is positive to the forward outlook for equities. 

  • A decline in the pass-through rate from 39.6% to 25%; While this adjustment doesn’t directly impact publicly traded companies, the large majority of all U.S. businesses are classified as pass-through entities (sole proprietorships, partnerships and S-corporations). The name comes from the profits and losses of such businesses that pass through directly to their owners, unlike public corporations. Pass-through profits are now taxed at top individual income-tax rates as high as 39.6 percent, higher than the top corporate income tax rate of 35 percent — a disparity that pass-through business owners have long complained about.  Overall, we feel that this will have a positive impact on small business USA…and therefore the overall economy. 
  • 5 years in which businesses will be able to fully expense their capital purchases; Capital Expenditures, or the lack there of, have been a point of discussion for years. Since 2008, rather than invest capital in long-term projects that can help stimulate the economy, corporations have used their extra cash to pay dividends and buy-back stock (one of the easiest ways to financially engineer earnings growth).   While we believe that this change will have minimal impact on corporate earnings growth (especially given that we are late in the economic cycle), we are thrilled that businesses will be incentivized to grow corporate earnings the right way – one that promotes economic growth. 
  • A move to a territorial system (i.e., minimal or no U.S. taxes upon repatriation of foreign earnings); A holiday to repatriate earnings held abroad at a lower rate of 12% would likely see approximately 50% or around $500 billion of the approximately $1 trillion cash reserves held outside of the U.S. come back.  Note that approximately 85% of the companies with foreign cash are household technology and pharmaceutical companies such as Apple, Microsoft, Cisco, Oracle, Merck and Amgen. Some of these companies may reward shareholders with dividends and buy-backs as current cash needs for most businesses on the list are low. The one caveat in this plan is that many of the same accounting tricks that multinationals used to build up large cash positions will be disallowed under the proposed new tax regime. This should dampen the appeal of accounting tricks that have helped drive earnings abroad for many U.S. multinationals. 

Overall, we believe a number of the details and timelines will change over the next few weeks as differences between the two versions are ironed out.  As always, we will keep you posted.

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Reid Davis serves as Chief Investment Officer at Pinnacle Trust. You can reach him by email at rdavis@pinntrust.com or by calling the office at 601-957-0323.