Broker Check

January 2018: Tax Reform for Christmas

Written December 21, 2017
I hope that your holiday season was full of joy and the coming year is full of promise.

The big news is tax reform. Last month the 115th United States Congress presented a huge bill to President Trump, which he signed into law. The changes to the tax code will affect nearly every American in some way. It’s important for financial markets because it lowers tax rates for both households and corporations and is likely to provide a boost to both the U.S. economy and corporate earnings. But as with any good thing, it comes at a cost. According to the Joint Committee on Taxation, this tax reform will add $1.5 trillion over ten years to the national debt. However, I take that with a grain of salt. Let’s be real. There may be more tax reform in the next ten years, so what we have ten years from now may look nothing like what we see today.

When we look at the timing of this, it’s interesting to note that its stimulating effects come at the same time the Federal Reserve is trying to raise rates and pull back on the reins. To put it another way, the Federal Reserve is on one end of a big hole with a shovel filling it with dirt, while Congress is at the other end digging the dirt right back out.

Typically, a fiscal policy like raising or lowering tax rates has an immediate impact on the economy. On the other end of the spectrum, a monetary policy like raising or lowering interest rates commonly has a delayed impact on the economy. With this in mind, the new law may give a short-term bounce to economic data, and the Fed’s raising of rates will very slowly drain it away. Maybe it’s a stroke of genius that will ultimately lead to an expansion of this business cycle. Maybe it’ll end in disaster. It’s too early to tell. But we live in interesting times, that’s for sure. Let’s take a look at some of the pertinent changes this new law has to offer.

Lower corporate tax rate
The single most important change for financial markets is the reduction of the corporate tax rate from 35% to 21%. The math gets complicated, but according to Russell Investments’ calculations, the actual tax bill for S&P 500 companies could be reduced by anywhere from 3-5%. That will boost 2018 earnings without corporations having to lift a finger.

Repatriation tax
Another important provision for businesses is the so-called “deemed repatriation[1]. " This is a one-time tax on $2.6 trillion of accumulated un-repatriated foreign profits of U.S. businesses. However, this probably won’t make a huge impact on corporations’ bottom lines. The bigger question is what companies will do with this money once they bring it back home. They could do share buybacks, but that really only helps shareholders if the shares are undervalued. There aren’t many undervalued stocks these days. They could use it toward mergers and acquisitions. This could benefit companies that are targets for take-overs.

Income tax reductions
The new law also overhauls the tax system for every taxpayer - and it’s complicated. The full text of the legislation is over 700 pages long, so I can’t go into too much detail here. The important bits are that it cuts income taxes for many families and lowers the highest marginal rate for individuals from 39.6% to 37%. It raises the standard deduction for couples to $24,000, so there’s a much higher hurdle to cross before itemizing makes sense. There is a $2,000 child tax credit added that will help make up for the fact there are no longer personal exemptions. For most people, this will probably lower their tax bill at least slightly and could boost consumer spending with those extra dollars. I say ‘could’ because it’s fiercely debated whether or not this actually occurs or if consumers largely do something more sensible like paying down their debt.

Bottom line
This new law has the potential to boost U.S. Gross Domestic Product (GDP) growth by 0.25% in 2018. The GDP was already accelerating, and this will add to that rise. That makes a recession in 2018 even less likely than it was before. It also adds extra tailwind for earnings growth due to slashed corporate taxes, so it’s likely that market returns will be positive. We are still in the very late innings of a bull market, so we always approach our optimism with caution. Tax reform is likely a short-term tailwind stocks and, as always, peering into the crystal ball to make predictions is a dicey game. For instance; some growth predictions are based on the assumption individuals and businesses will actually spend the extra money they get from tax cuts. Bear in mind, the economy is moving beyond full employment and the Fed is likely to take away any excessive fiscal stimulus with more rate hikes. Given the usual lag time seen with these kinds of adjustments to monetary policy, the new law could translate to strong growth in 2018 but set the stage for a potentially turbulent 2019.



Disclaimers and Notes

The views are those of Victoria Bogner and should not be construed as investment advice. All information is believed to be from reliable sources, however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results.

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