As we approach the end of the year, congressional Republicans are frantically putting the finishing touches on their promised tax reform bill. Since mid-2017, we have believed the odds of passage to be higher than consensus; this is one of the reasons we remained overweight equities in our multi-asset portfolios. With passage of the bill imminent, we thought it would be a good time to examine the implications of the second largest tax cut in modern U.S. history.
At its core, this bill is a corporate tax cut. The federal corporate tax rate is expected to decrease from 35% to 21% — and drop about 26% overall with state and local taxes included — putting it in line with averages compiled by the Organization for Economic Co-operation and Development (OECD).
While very few corporations pay the statutory tax rate, it should be noted that the average effective corporate tax rate should still fall about 5%. This decrease in the corporate tax rate provides a near-term boost for stocks, likely increasing 2018 earnings 5% to 10% for the S&P 500 and more for higher-taxed small-cap companies. Those higher earnings should then persist into the future, meaning stocks have greater value due to higher expected after-tax cash flows.
In the short-term, we may see additional corporate investment due to a provision allowing companies to immediately expense (rather than depreciate) their capital expenditures. Under current law, a company builds a plant and then depreciates it over a long period of time, reducing their tax burden a small amount each year. Under the new law, a company can expense the plant cost when it’s built, reducing its tax burden in the current year. Since this provision has a five-year sunset, we expect additional capital expenditures in the near term, which would be another boost for the economy. Higher investment may also increase worker productivity (people can be more productive when working with newer technology), the key laggard over the last two decades. The effects on productivity — if they materialize — may take years to observe but they are the key to the success of this tax bill.
The bill’s implications for individual taxpayers are more nuanced, with lower headline tax rates and a higher standard deduction balanced by fewer itemized deductions. Individuals (such as ourselves!) residing in high-tax states will have deductions on state and local taxes capped. However, overall tax rates should decline moderately due mainly to lower rates. We think these tax declines may lead to small increases in consumer spending as individuals start seeing larger net paychecks in 2018, though the effects will not be drastic.
There is a near-term risk and a long-term risk to this tax bill. In the near-term, lower taxes and higher capital expenditures could lead to a sugar high in the economy, especially in the context of the relatively strong growth we are currently experiencing. A boost in growth could then feed into inflation, causing the Federal Reserve to raise rates faster than markets expect and in turn imperiling the economy. The longer-term concern is that this $1.5 trillion net tax cut fails to deliver sufficient growth and saddles the government with additional debt. The Tax Policy Center expects this bill to increase the ratio of federal debt to GDP by 5.4% by 2027, even after projecting increased economic growth. While not crippling, this higher debt load could preclude additional fiscal stimulus in the event of another economic downturn.
We remain overweight both U.S. and international stocks as the market re-prices for the benefits from this tax cut. Analysts are still working to incorporate tax cuts into 2018 earnings expectations, and we expect upward revisions as a result. Some of the pro-growth implications — such as increased capital expenditures — are not fully priced into the market, providing further upside for both domestic and international developed-market equities.