Tax Reform Implications

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by: Manning & Napier

Congressional Republicans passed a sweeping overhaul of the U.S. tax code last week in what is the most significant change to tax policy in 31 years. The bill, titled "The Tax Cuts and Jobs Act," was signed into law by President Trump on Friday morning.

One of the central goals of The Tax Cuts and Jobs Act is to boost economic growth for most Americans through a combination of lower corporate taxes, a more streamlined tax code, and renewed incentives for real business investment, offset by a projected price tag of $1.5 trillion added to the deficit over the next ten years. At 1,097 pages, the legislation is long, and because it passed primarily along party lines, not all provisions are indefinite and the devil is in the details.

From an investor's perspective, the headlining feature of the Tax Cuts and Jobs Act is a slashing of the statutory corporate tax rate down from 35% to 21%. This major corporate tax rate reduction, along with the elimination of various deductions and exemptions that have become built into the tax code over time, hopes to level the corporate playing field between the U.S. and other nations, as well as across the various sectors of the economy.

Other key features include moving the U.S. to a territorial tax system, eliminating the corporate alternative minimum tax, reducing the deductibility of interest expenses and net operating losses, allowing the expensing of qualified capital expenditures, and various other changes to provisions, such as pass-through business income, university endowments, the Obamacare individual mandate, and more.

At a corporate level, there will be winners and losers from the scope of these changes. For example, domestically-oriented businesses may capture more meaningful tax savings than multinational corporations, as many multinationals already have a lower effective tax rate than the U.S. statutory rate.

Additionally, not all tax savings will necessarily drop to the bottom line; some industries are more likely to compete it away than others. To illustrate, many of the benefits for certain grocers such as Kroger (NYSE:KR) are likely to go back to the customer. Conversely, some auto part retailers have already stated that they will retain all of the benefits.

For companies that do see meaningful tax savings, the more favorable tax treatment of capital expenditures and foreign capital repatriation may create greater incentive for them to invest. These incentives may direct more capital into the real economy as opposed to financial operations such as share repurchases and dividends. In the event that some companies choose to invest in their people, this may feed into higher wages and could be a boost to inflation. However, if companies are planning on competing away the benefits, the impact could be deflationary or eat into the savings rate.

The implications of greater real business investment may reach across sectors. For example, multiple financial sector executives have suggested that potential tax savings may be reinvested into new technology and digital capabilities. Select financial technology companies would stand to gain from such an uptick in IT spending.

Business outlook, and in turn, investment for the future, may also improve as rules of the road become fully known and understood. As companies gain greater confidence in the tax environment they are operating in, they may become more likely to take on lengthy, long-run investment projects that capture economies of scale, improving efficiency and productivity.

However, it is important to note that the economy does not equal the stock market. U.S. equities have performed very well over the past year, in part due to expectations for pro-growth policies like tax reform getting done. While earnings growth may help drive returns from here, valuations are elevated and are likely to be a headwind, not a tailwind. Additionally, we continue to observe incremental signs that the economy is moving later cycle and risks are starting to build, even if they are not yet at concerning levels. In this environment, it will remain critical for investors to employ active risk management and selectivity in their investment approach in order to help protect capital and capture opportunities as they materialize.