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US tax reform enters the final stretch

Charlie Reinhard

By Charlie Reinhard

Head - NAM Investment Strategy

December 5, 2017Posted InInvestments and Investment Strategy

Earlier this month the Senate voted 51-49 to approve its version of a tax reform bill. The House already passed its version in November and now the two chambers need to reconcile their differences before sending a final bill to the President.

The centerpiece of the tax reform effort underway is to lower the corporate tax rate from 35% to 20% to make US businesses more competitive. A 20% rate would bring US corporate tax rates more in line with other developed countries and below the rates of China and Mexico.

The House plan would lower corporate taxes in 2018 while the Senate plan would wait until 2019. Potential tax cut winners have performed well since late September when tax reform moved to the top of the fiscal policy agenda.

Businesses will also benefit from accelerated depreciation of new investments, lower taxes on pass through income and a modified territorial tax system for multinational companies where firms are taxed based on where they generate business. There will be a one-time tax on current un-repatriated foreign earnings. However, the interest deduction for businesses will be limited to 30% of business income to discourage firms from taking on too much leverage.

The next most important feature of the tax reform plan is to roughly double the standard deduction on single and joint filers. The idea is to simplify the tax process and curb reliance on itemized deductions. In 2015, 69% of filers took the standard deduction, according to FiveThirtyEight, an amount that should only climb upon the passage of tax reform. A large portion of the 28% of filers who took deductions for state and local taxes (SALT) in 2015 will cease to itemize going forward.

That is because the average SALT deduction for middle-class taxpayers with earnings of $50,000 to $100,000 USD was just over $3,000 in 2015 while joint filers will see their standard deduction double to $24,000 in the Senate plan ($24,400 in the House plan) by way of comparison. In addition, the tax reform contains larger child tax credits. But not everyone will benefit. As of 16 November, the Tax Policy Center estimated 9% of filers would pay higher taxes in 2019 under the Senate plan but the average tax payer in all income groups would pay lower taxes. High income earners on corporate salaries living in high-tax states may pay higher taxes.

The Senate’s version repeals the individual mandate penalty of the Affordable Care Act (ACA) which was being paid by about 6.5 million filers, according to the IRS. These filers will no longer pay a penalty but the repeal is also likely to bring about higher costs for those keeping their health coverage and lead to a greater number of people who find they can’t afford coverage at these new higher prices. The Congressional Budget Office estimates 13 million fewer people insured.

To send a bill to the President’s desk, the two chambers need to reconcile the differences in their respective bills. The quickest way would be for the House to vote the Senate’s plan. If that doesn’t happen, we believe the final package will bear a strong resemblance to the Senate’s version, as the House assesses what can pass both chambers.

We believe tax reform passage is largely being discounted in the market at this time. The global investment committee estimates S&P 500 earnings per share (EPS) growth of 11% in 2017 and 6-7% in 2018 before tax cuts which would improve the earnings outlook upon going into effect. The House and Senate plans have different start dates which will be sorted out in the reconciliation process. At a price tag in the neighborhood of $1.5 trillion over ten years, we believe tax reform would provide some late-cycle stimulus to the US and global economies. This, in turn, could put a higher floor under the US dollar from what might have otherwise been the case. Longer-term, a lower after-tax cost structure with accelerated depreciation schedules may encourage some firms that sell their products into the US to produce more in the US.