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.

 

 

 

 

selling: average cost or specific shares?

I’ve had a Fidelity brokerage account for a long time.  I’ve been relatively happy, with only two complaints:

–The first is a “just me” concern.  The Hong Kong stocks I own are always mispriced, except during Hong Kong trading hours.  Other than when that market is live, prices are typically two days old.

I’ve discussed this numerous times with Fidelity representatives (who probably think:  “Oh, him again!”);  I’ve also mentioned this in many surveys I’ve filled out over the years.  Apparently, it isn’t important enough to fix.  Every once in a while a Fidelity trader will advise me to trade these shares on the OTC market in the US, where they will be priced in my account, if accurate quotes are so important.  I don’t see the advantage for me, since my experience is that in times of stress US volumes for stocks like these evaporates.   In such circumstances, my observation is that prices can easily be 5% -10% less favorable in the US than in Hong Kong.  They’re also cheaper to trade in Hong Kong, too, but that’s a lesser issue.

 

–The second is more serious.  For some years, brokers have been required to report gains an losses from trading in taxable accounts to the IRS.  Determining selling price is straightforward.  The default option Fidelity uses for the cost of the shares sold, however, is the average price paid for all the shares in the position.

This is apparently the easiest thing for Fidelity to deliver.  But it’s not always the best for the client.  And the layout of the Fidelity online trade ticket doesn’t really highlight this important issue.  Unless you click on the expanded ticket link at the bottom of the form, you won’t be able to specify the tax lots that will be sold.

What is this about?

Two considerations:

–gains from stocks held for a year or less are taxed as ordinary income;  gains on stocks held longer than that are taxed at the (lower) long-term gains rate (more information from Turbotax).  So all other things being equal, it’s better to recognize a long-term gain than a short-term one.

–I generally try to sell my highest-cost shares first.  This results in recognizing the largest loss or smallest gain.  A net loss can have a tax value (see the Turbotax link above); subject to the holding period rules, the smallest gain should also mean the smallest income tax payment.

An example:

Suppose I hold 100 shares of JPM that I’ve bought at $50 and another 100 at $80.  Both lots are short-term.

I decide to sell 100 shares and net $9000 for them.

If at the time of sale I specify the shares with the $80 cost, my taxable gain is $1000.

If I specify the $50 shares, my gain is $4000. (I would probably only do this if I expected to offset this gain with a loss from other stock sales or from losses carried forward from prior years.)

If I let the Fidelity computer do the work, my capital gain is $2500.

 

If I’m in the 25% tax bracket, my income tax on the sale will be $250, $625 or $1000–depending on how I handle my cost basis.

 

Yes, I’ll likely sell the remainder of the position eventually, so I’m only postponing tax by choosing the highest cost shares.  Even so, in the meantime I have more money to put back to work today if I minimize current taxes.