Brad Weafer, CFA, Chief Investment Officer
Upcoming tax policy changes should have a positive impact on corporate profits.
Investor and media attention remains focused on the policy agenda in Washington. The recent difficulty in attempting to change the Affordable Care Act highlights the challenges the current administration faces in pressing its agenda. Those challenges notwithstanding, the outcome on policy debates centered on corporate tax reform has direct implications for both corporate profits and financial markets. In this note we will attempt to frame the relevant issues and quantify the potential impact. Normally, any discussion of corporate tax rates and interest deductions would excite only accountants and actuaries. In this case, however, we see a broader appeal, given the potential for a constructive outcome for stock prices.
CORPORATE TAX “REFORM”
U.S. corporations are currently taxed at 39 percent when combining the 35 percent federal tax with the average state tax. Whether you affiliate Republican, Democrat or Independent, it’s difficult to argue that corporate taxes are too low relative to other countries. According to data compiled by the Organization for Economic Co-operation and development (OECD), the U.S. has the highest statutory corporate tax rate in the developed world (See Figure 1 below). In addition, the Tax Foundation (a D.C. think tank) ranks tax codes in terms of competitiveness reflecting both marginal rate and neutrality; the U.S. ranks dead last on this measure.
A major focus of the new administration is making American corporations more competitive. During the campaign, Donald Trump proposed lowering the federal corporate tax rate from 35% to 15%. With his economic team now in place, the White House has promised an official plan is coming soon. We do, however, have a framework from the House. Last summer, lead by House Speaker Ryan and Rep. Brady, House Republicans released a plan called “A Better Way”, in which they outlined a “strategy to create jobs, grow the economy, and raise wages by reducing rates.”* This proposal calls for the federal tax rate to fall to 20%.
“A Better Way” is intended to lower rates without increasing the federal deficit while reflecting anticipated improvements in economic growth (a process referred to as dynamic scoring). This means any tax cuts corporations receive from a lower rate must be met with offsetting savings from other changes in the tax code. The notion of a deficit neutral plan explains why you will hear the current proposal discussed as tax reform rather than a tax cut. Each deficit saving action called for in the House plan will have different outcomes for individual companies, while the rate cut will be more widespread. This has drawn significant lobbying activity on both sides of each contested policy point. While the details of eventual legislation are clearly important, the House proposal provides a general framework to assess the impact any tax code changes would have on equity markets.
We suggest investors focus on four key provisions that directly impact corporate profitability and consequently equity prices:
- The federal corporate tax rate
- Border Adjustment Tax (BAT)
- Interest expense deductibility
- Foreign income repatriation
POSITIVE EARNINGS IMPACT OF A LOWER FEDERAL TAX RATE
Treasury Secretary Steve Mnuchin stated the administrations targeted completion date for tax reform is the end of August. Polls of investors indicate most market participants believe a new tax code will be in place by year end. With that in mind we will focus on the 2018 calendar year to assess the impact of any changes. The current Wall Street consensus for earnings per share for S&P 500 companies is $148. This estimate assumes the current Federal rate remains unchanged at 35%. We estimate that dropping the rate to 20% would result in an 11% increase in 2018 earnings. A cut to a 15% rate would grown earnings even further: we estimate a 15% increase in earnings. Failure to repeal the Affordable Care Act, however, does have consequences. All else being equal, to remain “deficit neutral” without the cost savings associated with repeal, would necessitate a tax rate of 28%. Given that the Republican party was unable to gain the votes necessary to reform healthcare, the door is open for the President to appeal to center leaning Democrats for a compromise on tax reform. We propose an alternate scenario where the administration accepts a higher federal rate but moves away from some of the more unpopular and politically difficult aspects of the House proposal. Under this scenario, we would assume a 25% rate, resulting in a more modest estimated increase in 2018 earnings of 7%.
The tax cut will benefit some companies more than others. Companies with a greater percentage of sales outside the U.S. already benefit from lower tax rates in those international jurisdictions. According to the S&P Dow Jones annual “S&P 500 Foreign Sales Report”, the percentage of products and services produced or sold by S&P 500 companies outside the U.S. is 44%. Domestically focused companies stand to benefit the most from a lower rate. Smaller sized companies are generally more domestically focused suggesting small capitalization stocks should do better with a lower rate. Goldman Sachs compiles an index comprised of companies with the highest tax rates. After meaningful out performance in November and December 2016, shares of companies that stand to benefit the most from a rate cut have under performed the broader market by over 5%, reversing the initial out performance (See Figure 2 below). This suggests the market is not reflecting the potential earnings increases, therefore, there is opportunity to benefit through careful stock selection.
BAT AND REMOVAL OF INTEREST DEDUCTION FOR EARNINGS
The House plan calls for a Border Adjustment Tax (BAT) in an effort to favor domestic production of goods. The proposal disallows the deduction of imports from domestic taxable income. For the government, this would generate additional tax revenue to help reach the deficit neutral goal. It is unclear whether the administration supports the BAT. Public statements from the President and Press Secretary have often diverged, leaving investors confused. The debate is even more difficult for individual House and Senate members. The makeup of a congressional members’ constituency may have a greater influence than loyalty to party lines. What is clear for companies, is that this change effectively raises the price of their imports. Proponents of the tax point to economic theory that dictates currencies will adjust perfectly (a rising dollar) to offset this rising cost. Our experience suggests that in complicated markets like currency, the practical impact often is very different from theory. In a detailed study, Bank of America estimates a $4-6 decrease in S&P earnings assuming no change in the value of the dollar. This is a direct offset to the benefit the rate cut would supply. In addition to a currency effect, we would expect many companies to try to pass on the rising cost through higher prices. Those companies with more pricing power would be most immune from any changes, but profits of non-differentiated low margin retailers and petroleum refiners stand to suffer.
An additional revenue generating component of the House proposal is removal of the deduction for interest expense. This is akin to removal of mortgage interest deduction on a personal tax return. Those businesses that are most levered would lose a very valuable tax shield, a negative for profits. Bank of America estimates this change would decrease earnings by an additional $4-6 per share. Inclusion of the BAT and removal of this deduction would offset more than half our initial estimated positive impact.
In our alternative scenario, we would assume that neither the BAT nor the removal of the interest deduction would be included in final legislation. So, while the impact of a higher tax rate is relatively modest, removing the earnings headwind of these two provisions more than makes up for it.
FOREIGN INCOME REPATRIATION HAS BIPARTISAN SUPPORT
While the BAT and interest deduction have both political proponents and opponents, repatriation of foreign profits has much wider support. Under current law, profits of foreign subsidiaries of U.S. domiciled corporations are taxed twice, first in the country in which they are earned and second at the U.S. federal rate when those profits are repatriated to the U.S. Rather than pay the second tax, many corporations have let foreign profits accumulate, sitting unproductively overseas.
There are currently up to $2.5 trillion of assets in corporate coffers outside the country. Under the territorial tax system proposed by House Republicans, these funds would be taxed at 8.75% and companies could pay the resulting tax liability over eight years. There is debate on the appropriate rate (Trump’s plan used 10%, for example), but we have yet to see any proposals put forward that do not include a repatriation benefit in some form. Ignoring the longer term stimulative effect of bringing $2 trillion to the U.S., there would be an immediate benefit to per share profit as companies use some of these funds to repurchase shares. The Bank of America study estimates an increase of $4 per share in earnings if buyback activity is generally in line with experience witnessed during the repatriation holiday approved with the 2004 American Jobs Creation Act. Surprisingly, the stocks of companies that stand to benefit the most from repatriation have under performed the broader market since the elections (See Figure 3 below). This suggests there is still opportunity for investors to benefit from this legislative improvement.
ADDING IT ALL UP
There are still many details left for policy makers to debate. Negotiations on healthcare remind us that tax reform will not be a simple nor smooth process. When we sum the potential boost to S&P earnings from the combined policy changes however, we are optimistic there would be a positive impact to markets. We see very plausible scenarios where earnings move nearly 10% higher than currently forecast (See summary in Figure 4 below). Many other factors will ultimately influence corporate profits, especially growth in the global economy. And while we expect volatility to ebb and flow with the political debate, we expect tax reform to help support equity markets and to give active managers the opportunity to outperform passive alternatives
Please Note: Examples shown are for illustrative purposes only and do not represent the performance of any account, portfolio, composite of accounts or specific recommendation of Boston Financial Management. Your actual performance will vary based on your particular circumstances and should be adjusted to reflect management fees and trading costs. Investment in securities involves risks, including the risk of loss of principal. Past performance is not a guarantee of future returns.
This publication is for informational purposes only and should not be considered investment advice or recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Department of Labor Fiduciary Rule
by Charlie Zambri, Chief Compliance Officer and Director of Client Service
Many of you have probably heard of the Department of Labor Fiduciary Rule. This rule and its potential implications have been grabbing headlines since it was announced last April. Up to this point, we have not addressed the rule because of how much uncertainty there has been surrounding it. Uncertainty, both in terms of the rule itself and if it will actually be implemented. This uncertainty has grown since the Trump Administration took office in January. As of the date of this writing, the effective date of the rule has been officially delayed from April 10 to June 9. This comes as a result of an executive order from President Trump, requesting the Labor Department to review and potentially modify or repeal the rule. Regardless of if or when the rule goes into effect, we though you, as investors and our clients, should know more.
In its simplest terms, the Department of Labor’s definition of a “fiduciary” requires that advisors act in the best interests of their clients, and put their clients’ interest above their own. All potential conflicts of interest must be disclosed to clients. At this point, you might be thinking, “If you haven’t been acting in my best interest, in whose best interests have you been acting?” The good news is that as a Registered Investment Advisor, Boston Financial Management has always adhered to this fiduciary standard. We have a legal and ethical obligation to put our clients’ interests first.
However, not all financial advisors are bound by the fiduciary standard. Traditionally, stockbrokers, insurance agents, and other salespeople have only been required to operate under the suitability standard, which provides a lower level of accountability than the fiduciary standard. “Suitability” means that as long as an investment recommendation met a client’s defined needs and objective, it is deemed appropriate, regardless of any conflicts of interest it may create. At its heart, the Fiduciary Rule is meant to target this group by holding them to a higher level of accountability.
Fiduciary rule or no fiduciary rule, adhering to this standard is nothing new for us – we have acted in this fashion for all your accounts.
- We always put your needs first. We are committed to the highest professional and personal standards. Our sole focus is on your financial needs and goals and how we can best help you achieve them.
- We always act in your best interests. Your needs and goals always come before those of our firm. Though we strive to avoid them, if conflicts of interest were to arise, we would disclose them to you immediately. We provide a high level of transparency around any fees or expenses associated with your accounts, so there are never any surprises.
- We provide independent and objective advice. As an independent firm, we provide you with objective, unbiased advice based solely on your needs and goals. Our guidance is truly objective as we have no vested interest in particular products or services. Our only interest is helping you achieve your financial objectives.
Important: This article does not contain any legal or tax advice. You should always consult with your attorney, accountant or other professional advisors before changing or implementing any tax, investment or estate planning strategy.
IRC Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.