Eleven months have passed since the US stock market leapt on the news that Donald Trump had won the presidential election, and the assumption that sweeping cuts in corporate tax would follow. Many political escapades and alarms later, the new administration is at last coming to what many on the Wall Street regard as the subject that really mattered all along – tax.
Everybody has learned that political handicapping is difficult in the Trump era. His priorities are too hard to read, and his fractious relationship with Republicans in Congress is hard to predict. But the initial reaction to what is still a sketchy plan confirms what already appeared to be the case: markets first wildly overestimated the prospect of big tax cuts, but now wildly underestimate them.
Working out whether this will happen is a political judgment. The White House and the Republican majorities in both houses of Congress agree that a cut in corporation tax is desirable, but there will be a political food fight over the top rate of personal tax, and over whether tax cuts should be funded by cuts in spending, or be allowed to increase the deficit. Prediction markets, such as Predictit, have not moved much recently, and suggest that the odds are about 30 per cent of a corporate tax cut passing this year.
The inherent unpredictability of the situation creates risks in all directions, but the main risk at this point is to the up-side for US stocks.
This is, first, because the market seems to have discounted almost any chance of a tax cut. Goldman Sachs’ basket of the 50 S&P 500 companies with the highest effective tax rate (which stand to benefit the most), underperformed the 50 companies with the lowest tax rate by more than 11 per cent from last December as the market ruled out any chance of a cut. The high tax-rate companies have outperformed by 2.3 per cent in the last week.
Wedenesday’s sharp moves in the foreign exchange and debt markets, with bond yields rising across the world and the dollar continuing its recovery, also suggested that markets had not taken the chance of a tax cut seriously.
And yet the proposals would be a very big deal if passed, at least for US stocks and at least in the short term. After abandoning various ambitious reform ideas, such as the border tax adjustment, the plan floated by the administration for companies appears to have three key elements: a cut in the basic rate of corporate tax from 35 to 20 per cent; a one-time “repatriation tax” to encourage companies to bring cash home, and a shift to allow businesses to write off immediately all new depreciable investments.
According to Goldman Sachs’ David Kostin every one percentage point fall in the corporate tax rate adds a dollar to expected earnings per share for the S&P 500, which currently stand at about $US130 for next year, and have been drawn up on the assumption of no tax cut. That implies that the tax cut, if passed by the end of the year, would drive a one-off increase of about 11.5 per cent in expected earnings for next year. Obviously, that is a big deal.
Further, the gap between those who gain most and least, however, is wide and growing. According to Deutsche, the difference between the tax rate paid by top and bottom quintiles of the S&P 500 narrowed to just over 10 percentage points in 2002 . It is now close to 21 percentage points, back to its high from 1986, before the last big tax reform.
If the tax cut happens, it could mean quite a shake-up of recent market patterns. Technology companies, notoriously, are good at avoiding taxes, and pay only 23 per cent, according to Deutsche. So they will derive very little benefit – although some of the biggest names, including Apple and Microsoft, would stand to repatriate cash that they could then distribute in dividends, and activists will be ready to persuade them to do so. Healthcare, also in vogue in recent years, also pays a very low effective tax rate, of 24 per cent.
Meanwhile, the sector that stands to gain the most, by far, is energy, which pays an effective tax rate of 38 per cent. A “long tech short energy” trade would have lost a colossal 35 per cent starting in December last year. Energy companies have started to gain back some ground, thanks to the rising oil price; this could go much further if the tax cut happens.