The current tax reform looks to provide a near-term boost to the US economy. A family earning the median household income of $59,000 per year should see a reduction of taxes totaling approximately $1,000. Taxpayers earning between $75K and $100K would see an average tax reduction of $1600[1]. The size of the tax cut is largely proportional to income with earners in the $200-350K seeing an average reduction of $3,990 with continuing increases at higher income levels. While individual tax rates received only modest adjustments, corporate tax rates were reduced from 35% to 21%.
US corporate taxes have been among the highest in the developed world and have discouraged investment in the US. The costs of corporate taxes are primarily passed on to consumers through higher prices. Employees and shareholders also in part bear the costs. While reduced corporate taxes will boost the profitability of US companies, in most industries these excess profits will likely be competed away through lower prices which will benefit consumers. Additionally, the bill allows companies to repatriate offshore profits at a reduced rate of 8 to 15.5%.
Estimates vary on the overall economic impact. The Joint Committee on Taxation, the official scorekeeper in Congress, said the bill would boost growth the total size of the US GDP by 0.8 percentage points over the next 10 years, equating to approximately 0.08 percentage points additional GDP growth per year. Goldman Sachs estimates GDP growth will increase 0.3 percentage points above their baseline projection for 2018 and 2019. The analysts for the Penn-Wharton Budget Model said incremental growth would be between 0.06 and 0.12 percentage points per year.
How will this impact your portfolio?
Companies with primarily US operation will benefit the most from the reduced corporate tax rate. Banks face a high tax burden and will be among the primary beneficiaries of the tax cut. Smaller US companies that lack the complicated web of offshore holdings that typifies large multinationals will also see substantial savings. Whether the large US multinationals, particularly technology and pharmaceutical companies will take advantage of the reduced rate on repatriated cash to bring these funds home and invest remains to be seen.
MLPs will benefit from a 20% deduction to pass through income from the partnerships. This would apply to the income created by recapture upon the sale of units. Additionally, lower corporate tax rates will benefit the energy producers and refiners who are the MLPs’ customers. MLPs spent 2017 improving their balance sheets and distribution coverage and with record oil and gas production next year, should continue to see healthy volumes. Recent articles in Barron’s and other financial publications have begun to recognize the value in the sector and we believe this additional tax benefit will help steer investors back into this space in 2018.
Regulated utilities are one industry that does not stand to benefit. These companies will have to pass the tax savings onto consumers through a reduction in their rate base. This will potentially save households billions of dollars in electricity costs.
A loser from the tax bill may eventually be US Treasuries. The Congressional Budget Office expects the Federal deficit to increase from a projected 2.2% in 2018 to over 4% of GDP in the next decade. In recent years the deficit has been below the overall nominal growth of the economy, meaning that the total amount of US government debt has not grown relative to the size of the economy. However, the aging baby boomer population will require substantial increases in Medicare and Social Security expenditures over the coming decade. Unless Congress can come up with some meaningful reduction in future government borrowing will increase in the 2020s, putting pressure on interest rates.
What should investors be doing now?
While overall the near term impact to stocks looks positive, we are not recommending altering strategic portfolio allocations. Stock prices have anticipated this reform to some extent. It remains uncertain how long the boost to profitability of reduced taxes will last before it gets competed away, resulting in lower prices for consumers. With rich valuations and record low volatility, this ‘goldilocks’ environment could be easily upset by a negative economic or geopolitical surprise.
By Stephen C. Browne, CFA, CIO & CCO