With Donald Trump's first week as the 45th U.S. President proving to be full of controversy, perhaps the only thing more hotly contested than what the president has done in his first week is what he will do with his next four years. On the campaign trail Trump proposed a corporate tax reform that would aim to promote growth and make the U.S. a more attractive environment for businesses by cutting the federal corporate tax rate from 35% to 15%. Not surprisingly Wall Street is jumping at the plan as they see it as a way to retain a larger share of their pretax profits. In fact, it seems that investors are so behind the plan that, according to the website Business Insider, "Several top equity strategists, all bullish on stocks in 2017, told Barron's that the biggest risk of a correction is little progress on tax reform by midyear." With so much seeming to hinge on the Trump Corporate Tax plan there are a number of questions yet to be answered. How will this tax rate benefit the average investor? Which sectors stand to gain the most if the plan goes through? And perhaps the most looming, what will happen if the Trump organization fails to get it passed.
Effect on the U.S. Economy
Before considering how a possible tax cut could affect the general economy it is important to first make a key distinction. While the corporate tax rate, the 35% number, is the one that gets most discussed and referenced in the news most companies devote a large amount of their efforts towards finding ways to pay less than that number whether through deductions or other corporate taxes. This lower rate that companies end up paying after they have avoided all that they can is known as the effective tax rate. According to a study by Morgan Stanley, the aggregate effective tax rate paid across all sectors was 21.5% last year. A change in this tax rate could potentially have a large effect on the broader economy and its outlook going forward. According to the growth model published by the Tax Foundation, a nonpartisan tax research group, the Trump tax plan would have an increase in the long term size of the economy of between 6.9-8.2% over the next ten years compared to the baseline from the current policy. With this they expect the average citizen to reap benefits with wages jumping between 5.4-6.3% and capital investment rising somewhere from 20.1-23.9%. The plan would also result in between 1.8 and 2.2 million more full-time equivalent jobs during the same time period.
These rises in GDP, Investment, Wages, and Jobs all come as a result of the organization's projection of the effect the Trump plan would have on the amount of revenue generated by U.S. companies. The majority of the plan's economic impact comes from its corporate income tax reductions and reforms. The Taxes and growth model predicts that these account for 4.5% of the total 6.9% change in GDP. The Tax Foundation report then goes on to explain this increase in pretax income will allow for consumers to benefit from increased dividend payments and higher stock prices, driven by share buybacks. Overall this invest boost, paired with the predicted increase in the economy could stand to benefit the average investor greatly. While it is too soon to see where these reforms will be realized in full (which this report assumes), it is very clear how investors and companies alike stand to benefit if it does.
Sector Winners and Losers
As mentioned earlier, Morgan Stanley calculated the average effective tax rate paid by companies last year was 21.5%. However, this number is just an average, as the ability to avoid corporate tax varies widely with the sector a company operates within. As a result those sectors that currently pay the highest in corporate taxes stand to gain the most from a decrease in the marginal tax rate. On the other hand, REITs and Utilities which currently have the benefits of tax exemptions and deductions will be much less likely to see benefits and may even be negatively impacted as other sectors become more attractive in comparison.
In their 2017 Market Update, Morgan Stanley analyzed sector-specific earnings expectations for the S&P 500 companies for the upcoming year and looked at the potential effect of the tax rates embedded within those expectations from the Trump plan. Below is a graph that shows the effective tax rate paid by each of the sectors of the S&P and the EPS estimates with and without the Trump plan. The sectors that stand to gain the most from the proposed tax cut are Consumer Staples, Consumer Discretionary, and Telecomm with each of them seeing a more than 10% boost in EPS. Interestingly Morgan Stanley also projects that those sectors least effected by the Tax cut will see negative changes in their EPS with REITS and Utilities seeing an almost 12% decrease.
Overall the Trump policy seems to be a double edged sword with some sectors seeing large benefits and other large costs. Therefore in the coming year the it will be increasingly important for investors to watch the white house as the fate of the proposed policy has the potential to confirm or derail an allocation strategy.
Economic Effect of the Reform's defeat
With the growing level of pushback on President Trump's early policies it is important to consider the very likely possibility that the Trump administration fails to make progress on the tax reform within the first 100 days of Trump taking office or the reform never being implemented at all. If this happens many economist believe it could have a severe effect on a market that has made its expectations quite clear. David Seaburg, the head of sales and trading at Cowen & Co, when asked about the Reform said:
People want to buy stocks since Trump has been elected, but the market needs affirmation on Trump's tax plan. If that doesn't come at some point, you can see stocks trade off even more.
Seaburg then went on to say that this move needs to happen within the first half of this year because "If it doesn't come by that time, stocks could tank."
Other investors have echoed Seaburg's message as the Tax Reform has been pushed to the center of Trump's economic platform. If it were to fail the result could be a large pull back in a market that has been climbing ever since trump's election with the sectors that were set to benefit from the cuts feeling the bulk of the pain. While it is yet to be seen whether these changes will occur it is clear that the result, one way or another, will be the dominate trend at the forefront of the market's movement for the next year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.