Since the election there has been considerable talk of implementing fiscal policy to further stimulate the US economy. There is now hope that the gridlock in Washington will be broken and a “business friendly” agenda of tax cuts, infrastructure spending, and less regulation will be passed.
All of this is happening at a time when the Federal Reserve is seeking to reduce the amount of support it is providing to the economy. The net result of less support from the Fed combined with expectations for an economic boost from fiscal measures has propelled the stock market higher and provided upward pressure on the outlook for future growth, inflation, and interest rates.
This post is the first in a three-part series that aims to provide some detail on how the anticipated fiscal measures could impact the economy and markets. Below addresses the effect of tax cuts and repatriation while the next two posts will cover border adjustment taxes and infrastructure spending/de-regulation, respectively. It is important to note that fiscal policy only directly effects one part of the economy (government spending), but it can influence other areas including private consumption, business reinvestment, and net exports.
At this point in time, specific tax legislation has not been released and we could end up with a complete tax overhaul, a watered-down tax cut, or even nothing at all. Despite the recent set back in health care reform, Evercore ISI gives tax reform an 80% chance of successfully passing by March 2018.
According to the OECD, the top US marginal corporate tax rate of 39% (including state and local corporate taxes) is by far the highest in the industrialized world. But, the actual rate corporations pay after deductions is closer to 21%. President Trump has suggested reducing the federal rate from 35% to 15% to promote growth and improve the business environment for US companies. House Speaker Paul Ryan proposes 20% while 25% would likely appease congressional deficit hawks.
The impact on the deficit is important to consider as it will likely determine how many Republicans will go along with any of the proposals. One way of offsetting the expense of cutting the tax rate would be the implementation of a border adjustment tax or BAT. The idea is somewhat complicated, but is based upon taxing imports while subsidizing exports. Because the US imports much more than it exports, the result would likely be increased revenue into federal coffers in the near term. The details of a BAT get complicated very quickly, so the next blog post will cover the topic with more detail. However, according to the Bank Credit Analyst the end result of a 20% BAT would raise $100 billion in additional revenue. Since corporate taxes amount to roughly $350 billion per year, tax rates could be reduced by roughly 1/3 and still be revenue neutral with a BAT.
The impact to equity investors depends on just how much taxes are lowered on a net basis. Reducing the rate would lower tax burdens, but the effect could be offset by the additional costs of a border adjustment tax and the non-deductibility of interest expense. Bank of America estimated the effects of these changes for various tax outcomes in the table to the left. Their analysis assumes companies retain only half of the EPS benefit because some will be passed on to the customer in the form of lower prices. Ultimately the recurring EPS gain for the S&P 500 would be roughly $5.50 per year under a 20% tax rate scenario, which translates to a gain of 5% from 2016 realized earnings.
Repatriation of Overseas Profits
Currently US corporations are taxed on overseas earnings when they are transferred back home. Therefore, to avoid paying the 35% levy many multinational firms do not repatriate these earnings and leave them in offshore subsidiaries. It is estimated that more than $2 trillion is “locked” overseas. Bank of America estimates that nearly half of this amount is concentrated within 20 companies, such as Apple, Microsoft, and GE.
A mandatory tax on accumulated overseas earnings at a reduced rate is currently on the table and would likely force cash back to the US. Assuming no restrictions, cash could then be put to work in the form of investment, share buybacks, dividends and deleveraging. Assuming the cash is brought back home, stocks could receive a boost if companies declare special dividends or buy back shares. Bank of America estimates the earnings per share (EPS) impact of potential buybacks in the table to the right. If half of the repatriated cash is used for buybacks, S&P 500 EPS could increase by $4 per share in both 2017 and 2018.
Potential Market Impact
Currently, valuations are high relative to history which basically means investors are paying a high price today for future earnings. Lower taxes would improve the earnings picture and help valuations. Additional earnings could also boost business investment and productivity which has been weak in this post crisis expansion. Many specific details are still not known and details matter a lot! Corporations will ultimately make decisions based upon the net benefits of lower taxes, repatriation and the offsetting effects of taxes and interest expense deductibility. Despite the lack of details politicians seem focused on pro-growth policies which should ultimately yield benefits for companies and investors alike. Stay tuned for our upcoming post on BAT.
Brandy Niclai, CFA®
Chief Investment Officer