the Republican income tax plan and the stock market

The general outline of the Trump administration’s proposed revision of the corporate and individual income tax systems was announced yesterday.

The possible elimination of the deductability from federally taxable income of individuals’ state and local tax payments could have profound–and not highly predictable–long-term economic effects.  But from a right-now stock market point of view, I think the most important items are corporate:

–lowering the top tax bracket from 35% to 20% and

–decreasing the tax on repatriated foreign cash.

the tax rate

My appallingly simple back-of-the-envelope (but not necessarily incorrect) calculation says the first could boost the US profits of publicly listed companies by almost 25%.  Figuring that domestic operations account for half of reported S&P 500 profits, that would mean an immediate contraction of the PE on S&P 500 earnings of 12% or so.

I think this has been baked in the stock market cake for a long time.  If I’m correct, passage of this provision into law won’t make stock prices go up by much. Failure to do so will make them go down–maybe by a lot.

repatriation

I wrote about this a while ago.  I think the post is still relevant, so read it if you have time.  The basic idea is that the government tried this about a decade ago.  Although $300 billion or so was repatriated back then, there was no noticeable increase in overall domestic corporate investment.  Companies used domestically available cash already earmarked for capex for other purposes and spent the repatriated dollars on capex instead.

This was, but shouldn’t have been, a shock to Washington.  Really,   …if you had a choice between building a plant in a country that took away $.10 in tax for every dollar in pre-tax profit you made vs. in a country that took $.35 away, which would you choose?  (The listed company answer:  the place where favorable tax treatment makes your return on investment 38% higher.)  Privately held firms act differently, but that’s a whole other story.

 

The combination of repatriation + a lower corporate tax rate could have two positive economic and stock market effects.  Companies should be much more willing to put this idle cash to work into domestic capital investment.  There could also be a wave of merger and acquisition activity financed by this returning money.

 

 

 

 

US corporate tax reform (ii)

There are likely to be losers from corporate income tax reform.  They’re likely to be of two types:

–companies that currently have sweetheart tax deals, which, as things stand now (meaning:  subject to the success of intensive lobbying), will go away as part of reform.  A related group is multinationals who’ve twisted their corporate structures into pretzels to locate taxable income outside the US

–companies making losses currently and/or that have unused tax-loss carryforwards.  The value of those unused losses will likely be reduced by a lot.  This is a somewhat more complicated issue than it seems.  In their reports to public shareholders, money-losing firms can use anticipated future tax benefits to reduce the size of current losses.  The ins-and-outs of this are only important in isolated cases, so I’ll just say that for such firms book value is likely overstated

Another potential consequence of tax reform is that investors may begin to take a harder look at tax-related items on the income and cash flow statements.  Could markets will begin to apply a discount to the stocks of firms that use gimmicks to depress their tax rate?  Thinking some what more broadly, it may mean the markets will take a dimmer view of other sorts of financial engineering (share buybacks are what I personally hope for).  It might also be that companies themselves will reemphasize operation experience rather than financial sleight of hand when choosing their CEOs.

US corporate tax reform

 why look at the corporate tax rate?

As I’ve mentioned on occasion in other posts, one of the features of today’s US stock market is that it seems to pay no attention at all to the rate at which publicly traded companies pay tax.  All that counts is (after-tax) eps and eps growth.

A generation ago, when I entered the market, the opposite was the case.  Acting on the assumption that a company couldn’t sustain a super-low tax rate for a long time, analysts scrupulously adjusted, or “normalized,” a company’s tax rate, usually to the statutory maximum.  Of course, it has turned out that some firms–and some industries–have been able to maintain a sub-par tax rate for far longer than anyone imagined possible back then.

the US tax system

There are two main issues with the current US corporate tax system, as I see it.  The statutory rate of 35% is very high in comparison with the world average of around 20%.  So, if there isn’t a crucial reason to locate here, the US is financially a bad place for a company to have operations.  Also, politically savvy industries–oil and gas drilling, for example–have been able to lobby for special breaks that make the tax code unduly complex and the amount that the IRS collects less than it should be.

reform likely

President-elect Trump is promising to address this issue by lowering the federal corporate tax rate to perhaps 15%.  Implied, but not yet stated, is that the tax code will also be simplified by wiping out special exemptions for certain industries.  There seems to be widespread support for both parts of such reform.  So it seems to me that the effort, which has always previously been derailed by special interests, has a good chance to succeed.

market consequences

This means, though, that for the first time in a long while, analysts will be scrutinizing company financials to try to separate winners from losers.

potential winners

The obvious winners are firms that have large amounts of US taxable income and that pay cash taxes at the full 35% rate.  The pharmaceutical industry is one.  No surprise that most of the tax inversions of the recent past have been in pharma.

More tomorrow.