The H Group - Independent Wealth Management Solutions - Certified Financial Planning - Salem Oregon

The 1000+ page tax reform plan, the largest in decades, has been passed by both legislative chambers and signed into law. It moved surprisingly quickly, with initial debate about various components turning into a package that looked very much like the original submission.

The key component is the reduction of corporate tax rates from 35% down to 21%, which is substantial, and brings U.S. corporate rates closer in line with their global peers (noting that many corporations pay effective rates much lower than the maximum already, muting the impact somewhat). This will likely incent companies to keep their headquarters in the U.S., and reverse the trend of ‘inversion’ transactions in recent years, used by firms to isolate assets and profits in other jurisdictions to avoid U.S. taxation. In fact, accumulated foreign earnings will be repatriated at a one time tax rate. Now that firms are only taxed in the U.S. on U.S.-earned profits (not global profits), the incentive for such financial engineering is less. This was part of the point, as this is more in line with how many other nations tax their corporations. There are other aspects, such as allowance for 100% expensing of investment spending and a cap on deductions for debt interest, which may reduce the incentive for borrowing/issuing bonds.

Of course, investment markets are pleased with this outcome. Lower corporate rates mean lower expenses spent on taxes, which translate to higher earnings. No doubt, valuation premiums for equities incorporated the high probability of a tax plan passing, which could raise earnings as much as 5-10% for 2018 and beyond, which is meaningful. This also could create better economic growth overall, taking real GDP 0.25-0.50% or so higher for next year, with effects perhaps dissipating in later years based on where we end up in the business cycle. The effect on overall growth appears more modest than overly robust. Part of this is due to the fact that capex spending has remained low during the recovery, with profit gains tilted to global investments as well as other uses such as shareholder buybacks, and dividends, to a lesser degree. Overall, the general opinion is that corporate America and stockholders should be pleased with the plan. Naturally, though, as economic growth speeds up, this could also speed up the rate of Fed activity to hike interest rates to keep the pace of growth in check—estimated at this rate to be 3-4 hikes in 2018.

Municipal bond markets should see subtle changes, as opposed to radical ones. Their tax-advantaged status overall was retained (the fear of removing this special status always surfaces when broader tax changes are reviewed, even if a minor probability), as was the preferred status of private activity bonds—presumably due to their potential usefulness in any efforts for upcoming infrastructure plan borrowing. The key change was an elimination of the tax-exempt status for ‘pre-refunded’ bonds, which is when municipalities essentially refinance their debt by paying off higher-rate bonds early and collateralizing the proceeds with U.S. treasury assets.

Benefits also accrue to ‘pass-through’ entities, as in S-Corps and LLCs, that often fall in the gray area between separately taxed C Corporations and personal taxpayers—income is passed-through to partner owners. The tax act specifies that as much as 20% of pass-through income can be sheltered from tax—thereby lowering overall taxable income for such entities.

Interestingly, households have been less excited—despite stats showing that about 75% of the net tax cuts in the final bill are targeted to individual taxpayers (as opposed to only 60% in the original House version), with impact based on individual tax bracket and state of residence. Technically, cuts for individuals are slated to expire in 2025, unlike the corporate cuts. Higher tax bracket payers fare better, with top rates falling and the threshold for AMT and estate taxes rising significantly. For moderate income households, the deduction reductions for state/local taxes (down to $10k) and mortgage interest (on principal amounts up to $750k only) represent a mixed bag. With state and local income tax deductions capped, it’s possible that some residents of high-tax states such as CA, NY, NJ and others may end up paying more tax on a net level than before. Residents of other states may see reductions in overall taxes. Lower-income households also experienced a less clear result, with the standard deduction being doubled (albeit with the personal exemption being discontinued). While Obamacare was not repealed, the requirement that everyone have insurance (via penalties for not doing so) were removed, which could ease some household budgets. The impact of this bill on households could be mixed to muted on a more direct level, but tax savings are thought to translate to more spending, which is stimulative to the economy overall.

Some argue, at this later point in the cycle, where growth is already as robust as it’s likely to get, how much stimulus is needed? And, could such stimulus eventually prove detrimental, such as boosting labor markets that are already beyond levels of full employment? If interest rates do eventually rise for treasury bonds, paying off higher levels of debt at higher rates will certainly add to long-term burdens, as opposed to lessening them.

There will no doubt be much more analysis about this reform bill in the weeks and months ahead, but the above provides a broad-brush snapshot. Next on the agenda for the new year could be additional spending for infrastructure, which could be easier or more difficult than tax reform; however, it could likely be a lot more expensive.