Last month, with tongue firmly planted in cheek, we called for an “all aboard” onto the tax reform train. We hope you read between the lines to understand that we felt any form of tax cut / reform would be no easy task in the current political environment. After much publicized and often heated debate, we now have tax cut proposals from both (Republican controlled) chambers of Congress. Based on recent market and political reaction, our skepticism was and continues to remain warranted. Let’s take a quick look at the two bills.
First, let’s recognize that reforming the tax code is politically difficult. The House version attempts some level of reform by, among other things, eliminating most itemized deductions and popular expense deductions (such as those for medical expenses and student loan interest) and offsetting the impact with a higher standard deduction. The Senate version also doubles the standard deduction, but leaves the expense deductions alone. In another effort at reform, the House version reduces the number of tax brackets from 7 to 4, with the awkward result that some tax brackets see their tax rates rise. The Senate bill avoids raising anyone’s marginal rate, although they do leave a few the same.
As for the wealthiest taxpayers, even the House plan, which leaves their marginal rate unchanged, offers them the potential for lower tax payments. We say “potential” because it can depend on other items as well, such as SALT! Remember the discussion of “state and local taxes” from last month? Despite the negative media coverage, both versions throw out the deductions for SALT, with the House’s version maintaining property tax deductions. We still see the elimination of SALT deductions as a critical stumbling block to both plans.
Much to our relief, the bills leave the treatment of contributions to 401k plans and retirement accounts alone. Other issues that affect your investments include: no change to capital gains rates; the mortgage interest deduction stays, although the House version caps it to $500,000 of mortgage debt and limits it to the first home; and the estate tax exemption is doubled (the House plans to eliminate the estate tax itself after 2024).
For businesses, the two main items are a proposed 20% corporate tax rate and a change to the treatment of offshore earnings. For accumulated earnings already held in foreign subsidiaries, a one-time tax would be applied at a rate of between 5%-14%. The House bill would implement the 20% tax rate next year, while the Senate bill would wait till 2019.
Economic commentary suggests the economic impact of the House bill would be limited. This was reflected in the action of stock markets, which met the announcement of the House proposal with little change. While stocks fell on the announcement of the Senate version, they simply went back to the levels they closed following the House announcement. Both versions reflect a $1.5 trillion tax cut over ten years, but the House version aims to be deficit neutral after the 10-year window. Because it alone meets both these conditions (at the time of writing), only the House version can pass the Senate with a simple majority (meaning, with only Republican votes) using the budget reconciliation process.
We at Stone Bridge continue to believe that the possibility of a tax cut is not the primary driver behind current market conditions, but that the primary drivers are corporate earnings and global demand. We see both having continued strength. As an example, 73% of companies reported 3rd quarter earnings better than expected. We still believe that the biggest risk to equity markets is an unexpected increase in inflation. With the long-term interest rate below 3% and using the yield curve as our guide, it appears that there is little evidence of inflation risk any time soon.