• Wealth Management

Corporate Tax Reform: The Debate Takes Shape

Corporate tax reform could be a boon for U.S. companies, but investors should understand the nuances of the changes on the table.

U.S. stocks have rallied on expectations that President Trump and a Republican-controlled Congress will push forth a number of pro-business actions, from deregulation to infrastructure spending.

Yet, corporate tax reform may be the biggest boon of all. “It has the potential to quickly change the investment landscape, and across a wide range of sectors," says Lisa Shalett, head of Investment and Portfolio Solutions at Morgan Stanley Wealth Management. “By some estimates, a reduction in corporate tax rates could add between 7% and 10% to S&P 500 earnings."

While Morgan Stanley Wealth Management expects tax reforms to be comprehensive—with changes coming near the end of this year—investors should be temper their expectations. At the same time tax reform is rife with complexity and controversy, the market has already priced in many of the benefits, raising the risks of “policy disappointment."

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In a recent analysis of tax reform, Shalett and her team looked at the relative probability and potential implications of tax changes currently on the table. The menu includes many controversial moving parts: reducing the corporate and individual tax rate; a one-time repatriation on foreign earnings; potential for immediate expensing of capital investment; removal of interest deductibility; removal of tax credits; and potential for border adjustability.

Their conclusion: There is a high probability of a reduced corporate rate and favorable repatriation tax, but the one likely tradeoff is more limited net interest expense deductions.

What's more, the overall impact of tax reform will vary from sector to sector, and even company to company. “This further raises the potential value of stock picking over passive investing," Shalett adds.

Here are four things investors should consider as they look to make sense of possible reforms.

Impact on Debt and Deficits Key

With a top corporate tax rate of 35%, the United States is among the least tax-friendly nations in the developed world. In an analysis of 35 nations, the Tax Foundation, a Washington, D.C.-based think tank, put it near the bottom on overall tax competitiveness and last for corporate tax competitiveness.

The sticking point is how to reduce taxes without raising national debt levels. “Achieving revenue neutrality will be extremely difficult," says Shalett, noting that different scoring methods and sources produce dramatically different estimates of the overall impact of tax cuts on federal revenue.

Using dynamic scoring, which factors for the economic benefits of tax cuts, the Tax Foundation estimates that the House GOP tax plan would have a minimal impact on revenue and improve long-run GDP roughly 9% over the next 10 years. Using the same methodology, the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution, estimates a $1.7 trillion to $2.2 trillion revenue loss over 10 years and with a GDP benefit at less than 1% over 10 years.

Tax Cuts Better For Some Sectors

Most observers aren't questioning if the corporate tax gets a haircut but when, how and by how much. Morgan Stanley Wealth Management expects comprehensive reform to be rolled out via the 2018 budget reconciliation process at the end of this year.

President Trump has called for cutting that by more than half, to 15%, but the House GOP plan of 20% is a more reasonable target.

And while all U.S. companies could potentially benefit from a lower corporate tax rate, the effect on their bottom lines won't be universal. “Domestic-oriented consumer firms, which have relatively few tax breaks, would tend to benefit most," says Shalett, whose team estimates that a 20% corporate tax rate, no minimum tax on foreign earnings, and 100% interest deductibility limitation could boost telecom earnings per share by 11%, and add 9% and 8% to financials and tech respectively.

 

S&P 500: Estimated Change Under 15% and 20% Tax Rate (as of 1/31/2017)

2017E EPS Impact
Current 2017E Estimate 15% Corporate Tax 20% Corporate Tax
$ % $ %
Tech 28.3 1.70 6.0% 2.27 8.0%
Financials 23.9 3.35 14.0% 2.16 9.0%
Health Care 20.7 1.86 9.0% 2.28 11.0%
Cons. Disc. 14.7 2.06 14.0% 1.18 8.0%
Industrials 13.1 1.18 9.0% 0.52 4.0%
Cons. Staples 10.8 1.30 12.0% 0.86 8.0%
Energy 5.4 0.32 6.0% 0.21 4.0%
Telecomm 4.2 0.88 21.0% 0.46 11.0%
Utilities 4.2 0.54 13.0% 0.12 3.0%
Materials 3.6 0.18 5.0% 0.04 1.0%
Real Estate 3.7 0.15 4.0% 0.15 4.0%
All Sectors 132.6 13.52 10.2% 10.25 7.7%
Source: Morgan Stanley & Co Research, Taxes: Knowing Is Half the Battle, December 15, 2016, Morgan Stanley Wealth Management GIC

Don't Overlook Deductions

Changes in tax rates are just part of the picture. Investors should also consider how changes in deductions could impact companies, for better or for worse. One solution for achieving revenue neutrality—cutting taxes without adding to national debt—is to limit corporate interest deductions. Real estate companies, utilities and telecommunications companies are most likely to feel the squeeze if such a write-off is lost and all sectors are treated equally.

 

Interest Expense as a Percent of Sales (as of 1/31/2017)

Source: Haver Analytics, Bureau of Economic Analysis, FactSet, Morgan Stanley Wealth Management GIC. Note: Real net private saving includes domestic business and household saving adjusted for inflation. Real net private domestic investment includes investment made by domestic business and households and institutions adjusted for inflation.

At the same time, tax reform could offer immediate deductions of capital expenditures, as opposed to the current treatment in which these investments are amortized or depreciated over time. Small and medium-sized companies, which have more to gain from immediate capital expenditures deductions, could have an edge under this scenario.

 

Capital Expenditures and Interest Expense
as a Percent of Sales (as of 12/31/2016)

Source: FactSet, Morgan Stanley Wealth Management. Note: Smoothed median tax rate is the trailing 12-month moving average of the median effective tax rate within each cohort.

Closing The Loop On Tax Avoidance

Given the high U.S. corporate rate, it's no surprise that corporations are looking to keep their foreign earnings abroad for as long as possible or move out altogether by re-incorporating in low-tax countries. The proposed solution is to lower the corporate tax rate and entice companies to return offshore earnings by offering a reduced repatriation tax.

While President Trump's plan calls for a 10% repatriation tax—versus the current corporate rate of 35%—the House GOP plan is even more generous: 8.75% on cash and 3.5% on earnings.

Morgan Stanley’s Wealth Management Investment Resources team has compiled a client presentation, “Tax Reform: Key Themes and Issues,” which reviews these and other tax policy implications in greater detail. If you’re a Morgan Stanley client, contact your Financial Advisor to obtain a copy. If you’re not currently a Morgan Stanley client, use the locator below to find a Financial Advisor near you. 

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