Impact of the Tax Cuts and Jobs Act

Published on Jan. 29, 2018

Impact of the Tax Cuts and Jobs Act

While it is still too early to fully understand the implications of President Trump’s new tax law, we are seeing signs that the tax changes may have more positive impacts than previously appreciated. Perhaps to no one’s surprise, a lot of political rhetoric accompanied the bill’s debate and passage, and that debate may have obscured what could be positive impacts from the standpoint of the U.S. economy.

One meaningful change is the 40% decline in the corporate tax rate, cut from 35% to 21%. While many companies pay less than the full rate anyway, the reduction is substantial for a company which is actually paying the full 35% rate. Assuming a business generates $1,000,000 of pre-tax income, for 2017 their federal tax would be $350,000, but that will decline to $210,000 in 2018. This hypothetical company just saw its after-tax earnings go up by 21.5% (from $650,000 to $790,000), without any extra investment or hours worked.

In addition to this possible boost in after-tax income, companies which keep cash outside of the US, to avoid paying US taxes on those funds, should benefit from the reduction in taxation on that cash. This reduced tax could cause some companies to bring that money back to the US (sometimes referred to as “repatriating”). For some companies, this benefit will equate to billions of dollars. While this repatriation benefit is one-time, the income tax rate reduction is ongoing.

An important question is what will companies do with the benefits of this tax reform? Some market pundits believe companies will use their extra cash to purchase their own stock or increase stock dividends, or perhaps engage in merger and acquisition activity. Other commenters believe that these companies’ customers and employees could benefit from the tax changes in the form of increased compensation or lower prices.

In fact, we have already seen media reports that over a dozen companies in the S&P 500 index indicated they intend to pay employees a one-time bonus of up to $1,000 and boost hourly wages. We will hear from more companies in the coming weeks as they provide their quarterly earnings reports, and we believe it is possible they too will give guidance on what they plan to do with any extra funds resulting from the new tax changes.

JP Morgan, the largest US bank and one of the first companies to report fourth quarter earnings, provided some detail during a recent conference call of how it would allocate its benefit from tax reform. JP Morgan advised that while it awaits further clarity on the exact details of the tax reform, it expects some or all of the following to take place that would not have occurred absent the tax bill (in no particular order):

some of the benefit will be competed away

  • it will invest in global expansion, new technologies, and opening offices
  • it will increase employee benefits and hire additional bankers
  • it will consider decisions related to dividend policy and share repurchases (keeping in mind that regulators dictate the extent to which banks are permitted to return capital to shareholders)
  • it will consider providing subsidies to low income borrowers and support for small businesses

With respect to benefits being “competed away”, we understand JP Morgan to mean that since other banks are also going to receive tax benefits, many banks are likely to use some of the benefit to offer customers lower interest rates on loans or perhaps reduce fees on banking products and services. In other words, they could cut prices for products and services, a deflationary consideration that we believe many economists have not considered as a potential result of the tax act. (Relatedly, we also have seen reports of some utilities stating they will use a portion of their tax cut to reduce customer electric rates.)

We believe that JP Morgan’s comments are instructive and likely to be similar to what other firms are thinking. For those looking for rising equity prices, this new tax plan sounds pretty good. Companies could share their tax savings with customers, employees, and shareholders, and also make further investments in technology, facilities, and personnel. If one believes, as we do, that many companies are likely to follow in the footsteps of JP Morgan, we can extrapolate across the US economy and imagine an environment where wages and benefits are moving higher, prices for certain goods and services will be reduced, and investments will be made that were not even on the drawing board a year ago. In addition, to the extent that heavily indebted firms now see improvements to their margins and cash flows, this tax cut could have positive impacts from a credit quality standpoint.

In addition to the direct impact of corporate tax cuts, it is also worth considering the direct impact of tax cuts for individuals, as well as the indirect impacts of tax cuts for both companies and individuals. Many people should see an increase in their after-tax pay due to pay raises and cuts in tax rates. At least some of this additional after-tax pay will likely be spent on goods and services, providing an additional benefit to economic growth beyond the direct impacts noted above. Together, these direct and indirect benefits could provide a meaningful boost to economic growth in 2018 and 2019.

In summary, together with the strong macroeconomic data we have recently seen and elevated consumer sentiment numbers, we think the already favorable fundamental outlook for equities is made even more so by what we see as the likely positive impacts of corporate tax cuts.

Leave a Reply

Subscribe to Our Insights Today

Roosevelt Investments