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Strat Doc 1Q18 – US Tax Policy

30 January 2018

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by Peter Little

TCJA is the remarkably unhip acronym for the new US tax legislation signed into law on 22 December 2017 by President Donald Trump – the Tax Cuts and Jobs Act. It came into effect on 1 January 2018 and should create around $1.5trn of net tax savings for US corporates and individuals over the next 10 years.

The cuts are reasonably front-loaded with around half of the benefit accruing in the first three years. The impact is skewed towards individuals (around 80% of the savings), although the cuts for individuals are temporary and will start fading in the second half of the 10-year window, leaving individuals with net increases after the 10-year period. The cuts are permanent for corporates.

The biggest impact for individuals is through the lowering of the top marginal tax rate from 39.6% to 37%, the increasing of the bands for the lower rates and the doubling of the standard deductions. For corporations, the top rate is reduced from 35% to 21%, although this is offset by limiting the deductibility of interest payments, losses in prior years and other previously allowable expenses. The Tax Foundation, an independent, non-profit organisation, estimates that the impact of these changes in ability of corporates to deduct various previously allowed expenses will eliminate more than half the benefit of the tax cuts. In addition, the US is changing the way it taxes companies with operations outside of the US. Currently US multinationals pay tax in the US on foreign earnings at the difference between the US tax rate and the foreign tax rates (when those earnings are repatriated to the US), going forward only US domestic corporate earnings will be taxed by the US. Approximately $2trn of non-repatriated foreign earnings by US corporates will be deemed repatriated in 2018 and taxed at a reduced rate of 15.5% (for corporates holding those earnings in cash) and 8% (for corporates who have invested the earnings) – corporates can choose to pay this over up to eight years.

Figure 1: Net tax savings under TCJA

As far as the macroeconomic impact is concerned, empirical evidence suggests that individuals will spend c. 60% of the tax savings (if they have confidence that the savings are sustainable, which will become more of a problem after the first couple of years). This should add about 0.2%-0.3% to US GDP over the next few years (some of that consumption will be imported which could offset part of the boost to US GDP). As far as corporates go, the biggest impact to the US economy is likely to come from increased capital spending. Here TCJA has an additional incentive which allows corporates to deduct 100% of spending on equipment and machinery from taxable income in the year of purchase – this is effective for the next 5 years before the incentive starts fading. At first glance this seems a huge incentive for capital spending, though the benefit may not be as attractive as it seems given that the lower tax rates decrease the value of the tax deduction and the low interest rates make the present value of deducting the spending over multiple years (as was the previous treatment) not significantly different than the value of a full deduction in year one. Estimates of the impact from increased capital spending by corporates imply a 0.1%-0.2% increase in US GDP over the next couple of years.

TCJA also had a sting in the tail for those opponents of Trump’s desire to repeal former president Barack Obama’s Affordable Care Act, as it includes a removal of tax penalties for individuals with no healthcare, which is likely to leave around 13mn more Americans without healthcare. These are likely to be young healthy adults whose insurance premium typically subsidise the cost of healthcare for others – without those members, remaining members will likely incur higher health insurance premium.

In addition, TCJA included some minimum corporate tax levels to limit the opportunities for companies attempting to shift earnings to low tax jurisdictions.

In terms of asset valuations, the increased issuance of US treasuries to fund the tax cuts will likely place upward pressure on US bond yields. There are currently around $16trn of US Treasury securities outstanding, and the TCJA would increase that supply by 1%-2% p.a. for the next 5 years before tailing off. To put that increased supply into context, the supply has been growing around 10% p.a. on average for the last 15 years and over 5% p.a. for the 4 years ending 2016 (which is the latest available annual data). This means the additional supply is unlikely to meaningfully affect yields – inflation is likely to be the biggest driver of yields in the foreseeable future.

For equities the biggest impact will obviously come from higher after-tax earnings attributable to shareholders. All else being equal, a company with 100% US domestic earnings with an effective tax rate of 35%, which drops to 28%-21%, will have a 22% increase in after-tax earnings. Given that many large US corporates have significant foreign earnings and lower effective tax rates and that many of the previously deductible expenses are no longer available, the impact will be lower for many of them, with estimates placing the increased earnings for S&P 500 companies at around 5%-10% in aggregate. It is difficult to know how much of this is factored into already above-average ratings for US equity markets, it will hopefully become clearer as management teams are likely quizzed about the impact to their future effective tax rates when presenting their earnings results over the next few weeks and share prices respond.

Figure 2: Supply of US Treasury Securities

 

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