Tax Reform: Why Have Markets Remained so Skeptical?

Congress has reached important milestones in the journey toward the Trump administration’s promise of comprehensive tax reform. Since we first discussed its imminent arrival, the House passed a bill proposing sweeping changes to the corporate and individual tax codes. All eyes have now turned to the Senate, where legislators are hoping to pass their version of such a plan this week. Congress’s intention is to reconcile the two versions of the Tax Cuts and Jobs Act via a conference committee by mid-December. This special budget process allows for the passage of tax reform with a simple majority, eliminating the need for bi-partisan support and clearing the way for implementation into law by year-end.

Until this week, however, markets have been skeptical that anything will be achieved in the near term. Despite bouncing a few weeks ago, baskets of stocks that stand to benefit the most from tax reform have been underperforming, as they have done most of the year, according to Strategas Research Partners. The performance of small cap stocks, often heralded as significant beneficiaries of tax reform, have traced a similar trajectory relative to large cap stocks (see Figure 1 below). Bond yields have also not yet popped in a sustained way as many expected given the immediate economic stimulus that could ensue.

Yet the effects on economic growth and markets could be significant, even if only modest reforms are achieved. Though the Bush administration’s tax cuts were temporary, real economic growth surged from below 2% in 2002, to nearly 3% in 2003, and roughly 4% in 2004, before sustaining a level of above 3% in 2005. An echo of that experience will have important implications for corporate profits expectations and stock market valuations, especially since many anticipate central banks across the world will raise interest rates in unison next year for the first time since the Global Financial Crisis.

Given years of disappointment and frustration at Washington dysfunction, markets’ skepticism is understandable. But could they be setting themselves up for a positive surprise for a change? Let’s examine some of the reasons for their doubts.

1. Markets are worried that legislators have set an overly ambitious timeline. The details of the last effort at comprehensive tax reform took nearly two years to hammer out in the mid-80s. Having won 49 of 50 states in a landslide re-election, the Reagan administration had sufficient political capital to make difficult, long-term choices which became permanent changes to the law. That is in stark contrast to today’s polarized and partisan political atmosphere. With the prospects of our current single-party government lasting only until the November 2018 mid-term elections, legislators are highly incentivized to secure a legislative victory before then. Otherwise, the Trump administration may have to resort to compromises and temporary fixes, such as those seen under the Bush administration in 2003.
2. While the broad thrusts of the House and Senate plans are similar in nature, there are several material differences. Both reduce the corporate tax rate to 20% in an effort to increase the international competitiveness of big business. Both accelerate expensing of depreciation for new capital investments and limit net interest deductions to promote more investment and less financial engineering by companies. Both propose moving from a “worldwide” to a “territorial” system of taxation of international income to encourage companies to repatriate profits earned abroad. The Joint Committee on Taxation scores the value of the proposed tax cuts to be around $500 billion for corporate and international tax reform under each of the two plans. Where the plans differ significantly is the magnitude of tax relief proposed for pass-through entities, in which many small businesses are held, and individuals. The Senate bill proposes more than $600 billion of tax cuts to individuals by reducing marginal tax rates, whereas the House bill generates little more than half that amount. Instead, it focuses on simplifying the tax code by reducing the number of tax brackets. The House bill increases the estate tax exemption to $10 million, indexed for inflation, contemplating its repeal within six years, while the Senate plan doubles the exemption indefinitely. The House bill is also much kinder to small businesses, proposing nearly $600 billion of relief to pass-through entities against ~$200 billion in the Senate plan. Of high significance to business owners is how a final reconciled bill will treat the income of entities, including LLCs, LLPs, and S-corporations, which currently face a top marginal rate of 39.6%. Among other things, the House bill caps the pass-through rate at 25% and adds a lower minimum rate, while the Senate bills adopts a 17.4% deduction for pass-through income. Both plans focus relief for small businesses in manufacturing industries and restrict many companies in services industries from preferential treatment; this may have important ramifications for asset classes such as master limited partnerships (MLPs) and real estate investment trusts (REITs).
3. There are significant differences in how to pay for tax cuts. Senate budget rules allow for $1.5 trillion to be added to the deficit in the short term. The Senate recently threw out two wild cards to pay for these proposed tax cuts: first, delaying the corporate tax cut by one year, to 2019, so that the immediate effect on deficits is lowered[1]; and second, repealing the individual mandate requiring Americans to have health insurance. As we saw with the failure of healthcare reform, this is a very controversial topic; renewing that debate could make passing a Senate tax reform bill even more difficult. The idea that an automatic tax increase could be enacted in the future if tax revenues fall short of goals might assuage deficit hawks.

Balentine’s discipline has led us to emphasize stocks over bonds all year. It has cued off the improving fundamentals of higher global economic growth and corporate earnings while interest rates have remained low. Markets are not overly optimistic about the prospects of tax reform, but we are positioned to benefit from any upside surprise from Washington.

We will keep you informed on future developments. In the interim, please let us know if you have specific questions about this important unfolding topic.

[1] The Senate wants a one-year delay because the value of writing off capital investments (i.e., 100% expensing) will be a lot higher in 2018 at the current rate to further boost business investment. That, in turn, means that the effects on economic growth and earnings estimates from tax reform for 2018 are likely to be lower than in the outer years. This has potentially significant ramifications for how stock and bond markets react.