A Trader’s Guide to Handicapping Tax Reform Proposals
By Stuart E. Leblang, Geoffrey K. Verhoff, Amy S. Elliott, and Ryan Ellis
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Full Trump |
House Blueprint |
2014 Camp Bill |
Trump Lite |
Moderate (Senate) Compromise |
Modest Rate Cuts |
Add-On VAT |
Add-On Carbon Tax |
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Top Corporate Tax Rate |
15% (15% for pass-throughs) |
20% (25% for pass-throughs) |
25% (phased in over five years) |
20%-25% (plus special pass-through rate) |
25% (special pass-through rate) |
25% |
20% |
20% |
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Main Changes to the Tax Base |
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Treatment of Foreign Earnings |
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· DEEMED REPATRIATION |
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n/a |
n/a |
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Reviewing the Pros and Cons |
The tax reform plan that the Trump administration released on April 26 contained few specifics and proposed such a radical reduction in the tax rate on business income with no major offsets identified that such a plan would seem to face nearly insurmountable procedural and political hurdles. |
Radical base changes like border adjustments will pose o challenge to the Blueprint’s adoption. While adjustments may provide enough revenue to allow the plan to satisfy procedural hurdles (Byrd rule), they face extreme political opposition. Absent presidential leadership, the opposition may be fatal. |
The Camp bill’s most attractive feature is that it would survive the rules that mandate budget discipline (even using static scoring). However, there was little political support for the pion, particularly among Republicans. Comp did away with popular base broadeners, and many want the top rate under 25%. |
Trump and the Republicans in Congress need to enact business tax cuts before the 2018 midterm elections or they risk losing the majority in Congress. They may be prepared to come up with rosy economic growth figures in order to get such cuts passed in reconciliation without running afoul of the Byrd and other budget rules. |
If Senate leadership is prepared to find ways to maneuver around the Byrd rule (either by extending the budget window to 20 years or taking the Congressional Budget Office scores with a groin of salt, assuming Treasury thinks there will be growth), an approach that delivers more winners and fewer losers could pass. |
As long as Trump is willing to release his tax returns, there may be sufficient bipartisan support for a plan with modest rate cuts and base changes. |
Assuming that implementation of an add-on VAT comes with antiregressive measures and certain social programs were funded, some Democrats might be able to support this. |
Some Democrats could get behind such a reform because they are likely to support efforts to reduce carbon emissions associated with climate change. |
May 24, 2017
While the enactment of comprehensive tax reform faces numerous challenges, there is tremendous pressure on Republican lawmakers to deliver some form of tax relief while they control Congress and the White House. As traders may know, Wall Street responds more to certain tax changes than others. Economic growth and cash flow matter to some extent, but the financial-statement effects of certain tax changes can have dramatic impacts on stock prices:
- Public companies will be most responsive in a positive way to a significant reduction in corporate income tax rates; that is, unless they have accumulated sizable deferred tax assets, in which case a rate cut would trigger an accounting statement hit.
- The tax change that could give the second-biggest boost to stock prices is a tax cut on the repatriation of foreign earnings, which could boost dividends and stock buybacks.1
- While moving to a territorial system of taxation could have a similar bump, such a move would likely come along with measures to protect against base erosion (like a minimum tax) that could lessen the market’s response.
- Public company earnings could face a harmful and permanent noncash charge if Congress decides to limit the deductibility of net interest expense.
- If Congress enacts tax reform that provides for immediate expensing, public companies will not see a significant financial statement benefit, because their profits already take into account the deferred tax assets from future depreciation deductions.2 Expensing would merely exacerbate the temporary difference between book and tax.3
As the outlines of possible tax changes come into focus, the details of these five building blocks— headline rates, repatriation, territoriality, interest expense deductions and expensing—will figure prominently in how the market will respond. No one can predict what will happen, but the impetus for tax changes that will go into effect in advance of the 2018 midterm elections should not be discounted.
Many plans have been floated. Bold proposals to change the tax base, such as the House Republican Blueprint for Tax Reform entitled “A Better Way,” will be harder to achieve as they will require clearance of numerous political and procedural hurdles.
In whatever form it takes, tax relief will certainly require fundamental compromise. Reforms like simple tax cuts that seem relatively easy politically face significant challenges procedurally because of the many congressional rules that require a certain amount of budget discipline to avoid a ballooning deficit. (See our related article from May 22, “A Trader’s Guide to the Budget Process Necessary to Achieve Substantial Business Tax Cuts,” which includes a chart titled “Threats to Tax Legislation that (if Applicable) Can’t Be Waived by 51 Votes in the Senate.”)
The opposite is also true in that reforms that are paid for with base broadeners and other tax-hiking offsets create more losers, requiring strong presidential leadership to overcome.
The accompanying chart (page 1) outlines a few of the most discussed tax reform options ranked by likelihood, taking into account not only the political pulse in Washington at the moment, but procedural considerations like the reconciliation rules, dynamic scoring and business opposition. It also includes three compromises—none of which are likely at this point—that might, if the environment changes, be able to attract some bipartisan support.
This is only a snapshot, and these predictions will change, especially if factors like the pace of economic growth or presidential leadership suffer further blows. Our highly simplified take should help frame your thinking on what is at play. It is our strong belief that tax legislation in even a very narrow form is still likely, although it probably will not go into effect until sometime in 2018.
[1] If an individual company has an extraordinary amount of previously untaxed foreign earnings indefinitely reinvested offshore, then the ability to repatriate that cash at a reduced tax rate plus a move to a territorial system of taxation may matter more from a valuation perspective than an across-the-board corporate rate cut. On the other hand, if a firm has no deferred foreign earnings, then repatriation is not a significant factor.
[2] Gravelle, Jane G., April 25, 2017, “The ‘Better Way’ House Tax Plan: An Economic Analysis,” Congressional Research Service (https://fas.org/sgp/crs/misc/R44823.pdf).
[3] However, lawmakers are also considering changing the cost recovery rules for advertising and related expenses (including certain wages, package design and marketing research). Today such expenses are generally deductible in the year they are incurred. But some Republican leaders in Congress may decide to require taxpayers with significant advertising costs to delay the deductions for half of such expenditures, taking them instead over a 10-year period. According to its November 18, 2014, score of the Camp bill, the Joint Committee on Taxation estimated that slowing cost recovery for advertising expenses would generate $170 billion in revenue over 10 years, making it the fourth largest business tax pay-for in the Camp bill.
Key Contacts
