On December 22, 2017, President Trump signed into law the highly anticipated tax bill, and most provisions became effective on January 1, 2018. For the first time in over 30 years, we are faced with an overhauled U.S. tax code and revised regulations that have made it even more massive and labyrinthine. In our continuing effort to keep you abreast of the new law’s most significant potential effects on taxpayers, markets, and the economy—while never substituting for tax advice—we thought it would be fun to test your knowledge.
1. How does the Tax Cuts and Jobs Act (the Act) stack up against historical tax legislation (measured as percentage of gross domestic product, or GDP, averaged over the first two years)?
The Act will cut taxes for corporations and individuals by about $200 billion in 2018, equal to about 1% of GDP. That puts this piece of legislation second only to the Economic Recovery Tax Act of 1981 in terms of the tax revenue impact. Importantly, this is not to say that we expect U.S. economic growth to increase by 1%—as the true economic impact of the legislation will depend upon a number of factors, including how much of their tax savings individuals and corporations save versus spend.
2. How much do we expect the Act to add to GDP growth in 2018?
Our baseline estimate for 2018 U.S. real GDP growth (excluding any impact from tax cuts) is 2.25% year over year, just outpacing the post recession average. Once we factor in the impact of tax cuts, we estimate an additional 0.5%–0.75% in growth, bringing our estimate for 2018 real GDP growth to a range of 2.75%–3.0% year over year. We expect the biggest economic impact to come from increased personal consumption, as consumers find themselves with more discretionary income, and more capital spending, and businesses have more cash and greater incentive to invest in plants, machinery, and technology.
3. The Joint Committee on Taxation (JCT) estimates the largest tax savings in 2018 as a percent of federal taxes paid will go to:
Despite some misconceptions regarding the distribution of the Act’s cuts, those making $20,000–$30,000 will receive the greatest reduction in federal taxes paid, seeing a savings of 13.5%. This is important because consumers in the bottom of the income distribution have a higher propensity to spend than those in the wealthier income buckets, thereby meaning more of the tax cuts will make their way back into the economy rather than being saved. The Act’s estimates for the long-term impact of the tax cuts to individuals of various incomes differ and, in general, favor higher income distributions, due in part to their estimates of the lost Affordable Care Act cost-sharing subsidies.
4. Corporations are likely to do the following with their tax savings:
We expect that corporations will spend their tax savings and repatriated earnings in a number of ways. With the labor market the tightest it has been in over a decade, it is likely that labor competition and wage pressures will require companies to deploy some capital to retain and attract quality workers. Tax savings and greater incentive to invest in capital improvements (through 100% immediate expensing) are likely to lead to a continuation of the capital expenditures boost seen in 2017. Corporations will also almost certainly deploy some capital to buy back stock or increase shareholder dividends. One of the less appreciated destinations of tax savings could be price competition. In the wake of the Act’s passage, we are already hearing a number of retailers and other companies discuss “investment in price” to compete for market share, which would contribute to downward pressure on price inflation.
5. The sector to receive the least benefit from the reduction in the corporate income tax rate alone will be:
Technology has the lowest effective tax rate of any sector in the S&P 500, at about 23%, compared to roughly 27% for the overall S&P 500. A drop in the corporate tax rate from 35% to 21% will therefore be much less of a boost to the after-tax income of the technology sector than consumer discretionary, for example (which has an effective tax rate of 31%). However, we retain a positive outlook for technology, as the sector also stands to benefit from repatriation and a potential pickup in technology-related capital expenditures.
6. Our view is that repatriating overseas profits will have what effect on the U.S. dollar (USD)?
In our view, the outlook for the USD is mixed as a result of tax reform. On the one hand, higher growth that leads to inflation and a more aggressive Federal Reserve would be supportive of a stronger USD. Repatriation of overseas profits is also dollar positive. However, some estimates are that nearly half of overseas earnings are already denominated in USD, greatly muting the impact of USD being “brought home.” Long term, a higher U.S. debt burden from the cost of the tax plan could put downward pressure on the USD.
7. What effect is the tax bill likely to have on the municipal bond market?
One of the less-discussed details of the tax plan is the elimination of the tax-exempt quality of advance refunding municipal bonds, or bonds that are issued by a municipality—usually at a lower rate—in order to pay off an already-outstanding bond. We estimate advance refunding bonds constituted around 15% of the municipal bond market in 2017, thereby putting a significant dent in estimated supply for 2018. Also impacting supply was the threat from earlier versions of the tax bill to eliminate private activity bonds (PABs), e.g., higher education and hospital revenue bonds, which pushed up many issues from 1Q2018 to 4Q2017, ahead of tax reform. This rush to market resulted in December’s all-time monthly record of new issuance of $66B that was borrowed from 2018 supply. On the demand side, while the dramatic decline in tax rates for corporations may impact their appetite for buying municipal bonds, they represent a relatively small percentage of buyers. Individuals, on the other hand, dominate the ownership of municipal bonds and will experience only a minimal change in tax rates. Overall demand should be relatively unaffected by the tax changes. We expect the combined supply and demand dynamics to support prices for municipal bonds. (For more on this, see the 4Q17 Municipal Bond Commentary.)
8. How is tax reform likely to impact the taxable high-yield bond market?
Our outlook on the taxable high-yield bond market is mixed in light of tax reform. The Act limits the deductibility of corporate interest to 30% of earnings before interest, tax, depreciation, and amortization (EBITDA) for the next four years and 30% of EBIT (a less generous deduction) thereafter. This could strain high-yield debt issuers over the long term, particularly those in the lowest credit buckets, who typically rely heavily on their interest deduction as a means of managing balance sheets, in turn leading to an increase in defaults and a widening of high-yield interest rate spreads for this credit segment. However, non-investment-grade borrowers that do not exceed the 30% cap could see higher profitability from lower tax rates and stronger economic growth.
9. The reduced mortgage interest deduction, in our view, will:
The reduced limit of $750,000 for deducting mortgage interest is temporary (reverts to $1 million after 2025) and impacts less than 5% of the U.S. housing market. Regional impacts, however, could be more significant. As an example, in 3Q2017, about 19% of new homes sold in the Northeast cost $750,000 or more. However, changes to the standard deduction and state and local tax deductions will likely see the number of taxpayers who itemize—now about 30% of filers— reduced by 75%, according to the Tax Policy Center. This could have an impact on the after-tax return potential of owning a home.
10. What is one of the most underappreciated risks associated with the tax reform package?
There are always risks associated with market and economic forecasts. In our view, while there is a risk that the Fed moves quicker than the market expects, we expect the Fed to be more biased to letting inflation overshoot its target, rather than risk getting ahead of what have been only tepid inflationary pressures this past year. However, the cost of the tax package is concerning. While macroeconomic feedback effects are very difficult to accurately estimate, the $1.5 trillion price tag on the Act is unlikely to be completely offset by growth. The Congressional Budget Office already expects the federal debt held by the public to increase from 75% of GDP to 150% by 2050. Adding the JCT’s analysis of the cost of the tax legislation would exacerbate this even further—risking long-term private growth being crowded out by the debt burden.
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