A drop in the corporate tax rate. Elimination of a key deduction. Good news for muni bond investors. Morgan Stanley’s Michael Zezas details how the GOP tax reform proposal could play out.
Republican House and Senate leaders recently released their framework for tax reform and and plan details appear to align with Morgan Stanley’s base case for tax reform: slow progress toward 2018 passage, meaningful execution risk, and a moderation of rate cuts and deficit expansion relative to prior White House proposals.
As lawmakers consider the plan, here 9 key takeaways from the tax framework proposal:
1) Time is still needed to negotiate key issues
The tax release framework was big on cuts and short on specific 'pay fors'. The lack of detail has the strategic benefit of holding off lobbyists and individual members who may oppose specific pay fors. Yet in our view, this is a sign that some difficult special interest battles are ahead, suggesting Congress's true timeline for passage is longer than their currently stated goal of passage by year end.
2) Serious about SALT loss, but far from a done deal
In comments to the press that accompanied the release, the administration held firm to its plan to eliminate the deduction for State and Local Taxes paid (SALT). The SALT deduction is the fifth largest tax expenditure in the federal income tax code, and is projected to cost the U.S. Treasury $550B over five years. As one of the largest itemized deductions, it helps to pay for lower headline rates.
That said, we are skeptical that a full, immediate SALT repeal will become law since the politics are more complicated than they seem. Repealing SALT would likely result in a tax hike for high wage earners in high-tax areas, even after taking into account rate cuts. As such, we think that an income-based phase-out of itemized deductions, likely as part of a broader effort to offset the costs of an AMT repeal, is more likely than an outright repeal of SALT by itself.
3) The corporate tax rate could still go higher
We see the stated 20% corporate tax rate as a welcome sign that consensus is moving toward a more realistic plan. Given the procedural constraints for achieving a permanent corporate tax rate reduction, and the unattractiveness of a temporary corporate rate cut, our base case is that legislation will ultimately settle closer to a 25% rate given the political challenges of embracing the yet unidentified pay fors required to achieve 20%.
That said, the president called the 20% rate the "perfect number" and said he is "not negotiating that number," so we believe he will continue to push for as low of a rate as possible. In addition, some companies will be pushing for a corporate rate in the low 20s as a priority over other tax incentives on the corporate side. Therefore, you may see a continued debate over the corporate rate, with pressures on both sides, delaying progress.
4) Lack of details on pass-through rules is puzzling, but we expect lawmakers will push this to the regulatory process to avoid impeding legislative momentum
The framework included the 25% rate for pass-through businesses—which are businesses that pay taxes through the individual income code—but the framework did not include details on how the rules would be structured to prevent individuals from taking advantage of the lower rate. Those details will be tricky to define, and where there is gray area, there will be lobbyists. However, we could see the definition being pushed off to the regulatory process.
5) 5 more years of bonus depreciation
In line with our base case, the framework calls for what we read to be a 5-year extension of bonus depreciation policy by allowing immediate expensing of depreciable assets, other than real estate structures. This is effectively an expansion of current policy, which permits 50% of qualifying assets to be immediately expensed. Bonus depreciation has existed in various full and partial forms since 2008. On the margin, we don’t expect continuation of this policy to be materially stimulative. Recent research indicates that only 50% of companies use the bonus depreciation option and it only applies to ~$300-400 billion of investment per year.
6) Interest deductibility formally in play
The framework formally establishes a limit on interest deduction, in line with our base case. The question becomes, how deep is the cut? We believe the degree of the limitation will largely be a function of the give-and-take of other policy preferences along with the stated goal of a 20% corporate tax rate.
7) The municipal bond interest exemption appears safe
Although the plan document does not mention municipal bonds, senior administration officials confirmed that the plan would not eliminate the municipal bond interest exemption. In the absence of a concrete infrastructure plan, it appears that the administration is taking a 'do no harm' approach in choosing to preserve the municipal interest exemption. This is a positive development for the muni market. However, with spreads between tax-exempt munis and credit-quality-matched corporates implying a 30% tax benefit already, this good news appears to be largely priced in.
8) Still no bipartisan path, which means 'reconciliation' constrains outcomes
We were already skeptical of the idea that Republicans and Democrats would work together on tax reform. Cutting the top individual tax rate and eliminating the estate tax make it very unlikely that Democrats would support the plan. In addition, the willingness to increase deficits violates one of the Senate Democrats' principles for tax reform. Barring any significant changes, we think the idea of bipartisan tax reform that garners enough Democratic votes to clear the filibuster hurdle can be put to rest.
9) Look for the budget resolution, which will telegraph potential tax 'stimulus'
The "Big Six" indicated that they will now send these guidelines to the House Ways and Means Committee and the Senate Finance Committee so they can begin the process of filling in the details on tax reform. However, practically speaking, the next step in the process is for the House and Senate to pass a budget resolution with reconciliation instructions for tax reform. If Congress is able to follow Kevin Brady's timeline that he outlined a few weeks ago, the House and Senate would pass a joint budget resolution (it has to be the same one, so it may go to conference committee) by mid-October.
Members of the Senate Budget Committee came to a tentative agreement to allow $1.5 trillion in deficits for tax cuts, but have not yet acted in committee. In our view, this syncs with a modest near-term deficit expansion, but one that supports risk markets in the near term.
However, should the budget committee agree on a resolution allowing even higher deficits, or show a willingness to change the official scorer or extend the budget window, our call on tax reform could be too conservative. Stimulus would grow, risks would lessen for disruptive pay fors like interest deduction loss, and the floor on the corporate tax rate could decline.