Implications for the First Major Tax Overhaul in 30 Years

 

Before leaving for Christmas break, President Trump officially signed the Republican tax bill into law. The last time this country reformed its tax code, shoulder pads were in fashion, Mike Tyson became the youngest Heavyweight Champion in history, the Oprah Winfrey show had just debuted on television, and the movie “Wall Street” had not yet been released. Such sweeping reform obviously included many details and covered many issues. In the following paragraphs, we highlight a number of changes which have garnered the most interest to investors.
Individuals may start to see the impacts to their paychecks as early as this February, but will not likely feel the full scope of its effects until they file their 2018 tax returns in 2019. There will continue to be seven tax brackets; however, the thresholds will be higher and the graduated tax rates will be lower. The dreaded Alternative Minimum Tax (AMT) for individuals is being curtailed while the standard deduction was doubled and the amount one can deduct for mortgage interest and state taxes was reduced. The estate tax exemption and child tax credit were also doubled. The individual mandate for health care was repealed, so Americans will no longer be forced to buy health insurance or suffer a tax penalty for not having it.
For companies, the corporate tax rate is being cut from 35% to 21%, which brings the U.S. tax rate roughly in line with the rest of the world. The AMT tax for corporations was eliminated, and to incent corporations to repatriate cash, there is a one-time time break of 15.5% rather than 35%. Rather than using complicated schedules to depreciate over time, corporations can now expense 100% of the cost of eligible property through 2022. Investors may now deduct 20% of pass-through income, with the remainder taxed at the marginal tax rate.
For investors, advisory fees are no longer deductible, but tax rates on dividends and capital gains, tax lot-selling rules, and rules regarding 401k plans remain unchanged. Parents of school-age children may be happy to hear that 529 plans were expanded to include private K-12 education costs.
Looking to financial markets, likely early beneficiaries include companies doing the majority of their business in the United States and smaller companies, which tend to pay higher tax rates than larger corporations. Companies in sectors such as consumer staples, consumer discretionary, telecom and financials generally have higher tax rates and thus stand to benefit more than companies in technology, energy and REITs which generally have lower tax rates. Sectors that are domestically focused and consumer-driven - industries such as telecom, media and retail – may also benefit from consumers having more money to spend. New provisions for the treatment of capital expenditures should benefit manufacturing companies while REITs may profit from the changes to the tax treatment of pass-through income as well.
On the fixed income side, the municipal bond and high yield sectors will likely be the most affected, but the net impact is more difficult to project. As the rate for the top tax bracket is reduced, the benefit of owning munis is also ostensibly reduced; however, the reduction of state and local tax deductibility should support demand for municipal bonds. This will not impact all municipalities equally, though, and there will likely continue to be higher demand for bonds in states with high taxes and lower demand in states with low taxes. Currently, roughly 20-25% of the municipal market is held by insurance companies and corporations, and these entities, whose tax rates are being reduced substantially, may provide less demand for municipals. On the supply side, municipalities will no longer be able to pay off bonds early using proceeds from new bond issues at presumably lower interest rates, a practice referred to as “advance refunding.” This will reduce the supply of municipal bonds in the market. With both demand and supply falling, the net impact to the municipal bond market overall is harder to gauge. With respect to high yield, interest deductibility is being limited to 30% of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).

 

For a majority of companies in the space, this may be offset by the deductibility of capital expenditures, but highly indebted high yield companies may see their bond prices pushed lower.
In summary, there will be winners and losers in the tax plan. It remains to be seen how much is already priced in the market and how the tax plan will ultimately impact companies differently, even within the same sectors. Also, winners and losers may change over time as some of the taxes are phased out. In the short run, the plan will likely spur economic growth as consumers have more money to spend (consumption makes up roughly 70% of GDP), potentially causing inflation and forcing the Federal Reserve to raise interest rates more aggressively. However, increased wage and interest expenses may erode gains from reduced taxes. Thus, predicting how all this plays out is difficult. Additionally, economists estimate that the package will add around $1 - $1.5 trillion to the federal deficit over the next decade, depending on how much growth is generated from the tax package, and this will affect the economy and markets over the long run. Investors may wish to tactically allocate around some of these changes, but should keep their longterm risk and return targets in mind.

 


This report is created by Cetera Investment Management LLC

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