Lawmakers’ Full Court Press on Tax Reform
When Congress outlined an aggressive timeline to overhaul the U.S. tax code, few believed it could be realistically accomplished before the end of the year, but so far, lawmakers have delivered. While hurdles remain, the odds of tax reform becoming law are increasing.
Figure 1: While Hurdles Remain, the Odds of Tax Reform Passing in 2017 Are Increasing
Source: PredictIt, as of 12/4/17.
The Senate passed its tax bill 51 to 49 on Friday, December 1, edging Congress one step closer to success. The House and Senate now must reconcile differences (Figure 2), but it seems likely that a final tax bill will be produced.
Figure 2: Six Major Differences between the House and Senate Bills
|Hurdle Facing Tax Reform||Issue|
|Corporate Tax Rate & Date of Implementation||At a tax rate of 20%, the House proposes 2018 implementation, while the Senate waits until 2019. This affects the cumulative budget impact over the 10-year window, and thus, potentially other provisions as well.|
|Corporate AMT||Retained in Senate bill, repealed in the house bill. This undermines the R&D deduction and is facing resistance.|
|ACA Individual Mandate Repeal||The Senate bill repeals the individual mandate to purchase health care. The house bill keeps it intact.|
|Pass Through Tax Rate||The Senate bill puts a tighter cap on interests deductions than the house bill (30% of EBIT vs. 30% of EBITDA).|
|Corporate Interest Deduction||The house bill caps the pass through rate at 25%. The Senate bill is a bit less generous on rates but has looser guardrails on which income qualifies for the pass-through rate, and the provision expires in 2025.|
|Mortgage Interest Deduction||The House Bill limites the Mortgage interest tax deduction to the first $500k in principal. The Senate bill keeps the deductions intact for acquisition debt, but not for home equity loans.|
Sources: Strategas, NYLIM, as of 12/5/17.
What Will the Final Bill Look Like?
It is difficult to speculate the way the House and Senate will reconcile their differences. The issues are resolvable, but because Congress needs to follow strict budgetary confinements, a change to one provision would likely force changes in other areas.
As far as we can tell, the bill will offer a broad reduction in taxes, modestly boosting economic growth and lifting corporate earnings in the near term. However, tax cuts generally don’t pay for themselves, so we would likely see an increase in the deficit over the longer term.
What Does That Mean for Investors?
Some sectors and styles will fare better than others. Small- and mid-cap stocks, industrials, consumer staples, and telecoms currently pay the highest effective tax rate, and thus, stand to benefit the most from a reduced tax rate (Figure 3).
Figure 3: Tax Rates Differ by Size and Sector
|Sector||Effective Tax Rate|
|Sector||Effective Tax Rate|
|Mega Cap Companies||23.8%|
Source: Bloomberg, Reuters, S&P, NYLIM. As of 12/5/2017. Each tax rate is the median effective tax rate. Each sector is represented by the S&P 500 GICS Level 1 Sector. Small-cap companies are represented by the Russell 2000, mid-cap companies are represented by the Russell Midcap Index, large-cap companies are represented by the S&P 500 Index, and mega-cap companies are represented by the Dow Jones Industrial Average.
News on the progress on tax reform will be a dominant theme over the next few weeks. As lawmakers get closer to success, we believe the equity market will likely move higher and small-cap stocks will outperform large caps (Figure 4). Markets remain on the fence regarding whether tax reform will become law.
Figure 4: Small Caps Respond to the Likelihood of Tax Reform Odds
Bloomberg, PredictIt, NYLIM. As of 12/4/17. U.S. Large Caps are represented by the S&P 500 Index. U.S. Small Caps are represented by the Russell 2000 Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index definitions can be found at the end of this blog post.
A Failure Is Also a Risk
While tax reform may appear to be entering the final stretch towards passage, hurdles do remain, as Congress works on reconciling differences between the two bills. The market has priced in some success, which would unwind and could damage sentiment, posing downside risk. However, it is important to remember that the economy both at home and abroad is showing strong growth trends, and business capital expenditures and consumer spending are rising with or without a tax bill.
The Remaining Timeline for Tax Reform
There are three weeks to get this done in 2017:
- Week 1: Appropriations need to be completed, or the government shuts down (December 9). We expect that the House and Senate will temporarily extend the deadline.
- Week 1: The Senate and House will begin to negotiate the details of each plan.
- Week 2: Alabama will hold a special election for a Senator – the election could pose a risk to the passage of tax reform if voting is delayed into January, and markets are thus likely to pay attention.
- Week 2: Lawmakers aim to wrap up negotiations by December 12, with a full report published on December 15.
- Week 3: House begins proceedings to pass the bill and send it to the Senate for passage on December 22.
Congress has, so far, proven able to meet its deadlines. These deadlines will be watched closely by the markets. While a failure to meet a deadline will not necessarily represent a failure to reform taxes, as voting could in principle be postponed, it would likely result in some market volatility.
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Corporate AMT – The alternative minimum tax (AMT) is a supplemental income tax imposed by the United States federal government required in addition to baseline income tax for certain individuals, corporations, estates, and trusts that have exemptions or special circumstances allowing for lower payments of standard income tax.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe.
Russell Midcap Index – A market capitalization weighted index representing the smallest 800 companies in the Russell 1000 Index. The average Russell Midcap Index member has a market cap of $8 billion to $10 billion, with a median value of $4 billion to $5 billion.
S&P 500 GICS Level 1 Sector – All components of the S&P 500® are assigned to at least one of 10 Select Sector Indices, which seek to track major economic segments and are highly liquid benchmarks. Stock classifications are based on the Global Industry Classification Standard (GICS®).
S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock-market performance.
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