- There are two big things that can impact stocks, lower corporate taxes and a tax repatriation holiday.
- We’ll discuss which stocks would benefit the most and if it makes sense to invest in them now to reap any kind of benefit from tax reforms or a tax holiday.
- I’ll also share my opinion on the long-term impact lower corporate taxes would have.
There’s a lot of talk about tax reform and how it should have a positive impact on the markets. However, it’s important to understand what exactly could happen and how it could impact your portfolio.
In today’s article, we’ll discuss what all the fuss is about and see what the plausible impact on individual stocks and the stock market would be.
Corporate Tax Reform
While tax reform has not yet been passed, the main premises of it are the following:
- Corporate tax lowered to 20% from 35%.
- Possible tax holiday for global cash repatriation.
Let’s see how those changes could impact the stock market.
Impact Of Lowered Corporate Tax
Many think that a lower corporate income tax would help lower stock market valuations, but let’s first dig into that a bit more.
According to S&P Dow Jones Indices, 42% of S&P 500 revenue comes from outside of the U.S with 8.46% coming from Asia, 8.13% from Europe, and 2.57% from Canada.
Going deeper into the tax payments for 2016, 65% of corporate tax payments were to Washington. In 2016, total payments to Washington were $160.5 billion while payments abroad were $86.5 billion. Assuming a 35% tax rate, even if it’s lower than that as REITs make approximately 3.1% of the S&P 500, the total pre-tax U.S profit for S&P 500 corporations was $458 billion. Given that the S&P 500 market capitalization is around $25 billion with a price to earnings ratio of 25, we can assume that total S&P 500 earnings are around $1 billion. Given the 6% growth in earnings in 2017, S&P 500 companies could reach a U.S. pre-tax profit level of $500 billion in 2017 and a bit higher in 2018.
To make the calculation easy, let’s estimate $500 billion as fixed U.S. corporate profits. At a tax rate of 35%, the tax payment is $175 billion while at a tax rate of 20%, the payment falls to $100 billion. Thus, S&P 500 corporate profits would increase by $75 billion, or 7.5%.
Current PE ratio S&P 500 = Market capitalization / net profit
Current PE ratio S&P 500 = $25 trillion / $1 trillion = 25
Future PE ratio S&P 500 = $25 trillion / $1.075 trillion = 23.25
Thus, the tax difference would lower S&P 500 valuations by just 7% which would make things look a bit better, but not significantly better.
Let’s see what the potential impact of a tax holiday would be.
Tax Holiday On Foreign Cash Repatriation
U.S corporations have accumulated a significant stash of cash abroad because repatriating that cash would force them to pay 35% tax on it minus the eventual tax paid abroad. Given that tax rates abroad are usually much lower, companies have been reluctant to repatriate their cash in hopes of a tax holiday. Tax holidays aren’t uncommon and the last one was implemented in 2004 and allowed corporations to repatriate at a 5% tax rate.
The question is now, how much cash is there outside of the U.S. waiting to be repatriated at a lower tax rate? Some economists say the amount is around $2.5 trillion, Trump goes as far as $3 to $5 trillion, while Goldman and JP Morgan say it’s around $1 trillion.
A trillion that would be repatriated would already have a bigger impact on the stock market than a change in the tax rate. Where would that money go? Well, most probably into buybacks, dividends, and perhaps a few acquisitions. Don’t expect significant improvements in the economy, wages, or investments because U.S. corporations don’t have any problems with liquidity as most can borrow at extremely low rates, especially those who have a lot of cash abroad like Apple (NASDAQ: AAPL).
It’s interesting that in 2004, the 15 companies that repatriated the most after the 2004 repatriation holiday on overseas profits cut 20,931 jobs between 2004 and 2007, and slightly decreased the pace of their spending on research and development. Thus, we can expect the same to happen now as, I repeat myself, liquidity isn’t an issue.
However, let’s see who will benefit most from the tax holiday.
The biggest benefactors from a holiday would be tech companies like Apple, Cisco, Google, Microsoft an others that have a huge chunk of their profits coming from abroad. However, before jumping into investing in Apple, one must understand that a big part of that money and potential windfall has already been distributed as the company has almost $100 billion in long term debt that has been used to finance past dividends and buybacks. Nevertheless, the $256 billion would certainly increase the already positive environment surrounding Apple’s stock and possibly push it even higher.
Here we come to the first risk, as part of the tax benefits are already priced in to the stock with a part that will be priced in after the tax reform is confirmed. If the tax reform doesn’t happen in the expected manner, stocks might suffer.
A tax repatriation holiday will significantly benefit those companies who have large amounts of cash abroad as it will probably be used for more buybacks or dividends. Thus, by investing into such companies, you can take advantage of that. Or perhaps you can wait a bit before selling such companies as their valuations are already pretty high.
Another thing is that in the case of a recession, a tax holiday would become an even more interesting issue and companies that have a lot of cash would certainly benefit from that, so it’s a significant buffer.
A lower corporate tax rate could be beneficial to the competitiveness level of U.S. businesses, but won’t have such an impact on profits and valuations as the repatriation tax holiday could.
From a long-term perspective, what happens with taxes doesn’t really matter that much as companies have already accounted for those profits and nothing much really changes in the productivity or long-term outlook for a company. One thing that is certain, tax reform will keep this bull market alive for a while longer.
However, the situation and investing potential related to tax reform isn’t as profitable now as it was a year and a half ago when I wrote how the market didn’t even consider such an option and investors could get nice buffers in the form of benefits from a plausible repatriation tax. Back then, Apple was trading below $100.
To conclude, this corporate tax reform looks more like just something that will keep stock prices high or push them even higher. Something few understand is that such a situation is good only for those who are selling stocks at the moment, but isn’t good for the majority who still have to accumulate their retirement nest eggs. Higher valuations and buybacks simply lead to higher asset prices which means you get less for your money which in the long term will negatively impact your overall wealth.