Investing
10 Serious Risks and Opportunities for Investors Under Tax Reform and Tax Cuts
Published:
Last Updated:
When it comes to a dysfunctional political climate in Washington, D.C., every day people like you and me are thrown into the push-pull antics. We may all feel different about entitlements, benefits, health care, gun laws, and how the nation should be governed. One thing that actually boils down to a common complaint is how people are taxed. Some of us may want to be taxed less, and some may want other groups to pay more. At the end of the day, we all seem to care about the taxes we pay.
With tax reform, or at least tax cuts, looking much more promising than other efforts from President Trump and the Republican Congress, 24/7 Wall St. has decided to offer up 10 key issues that will matter to investors under changes to the tax code. The timing, and the ultimate impact, of any tax changes will remain up for debate, even as more proposals are released in the days ahead.
There are barely 50 days left until the start of 2018, and we all know that Congress isn’t working every one of those days. These tax reform (or cuts) may not apply to the tax year 2017, but they still may get applied retroactively.
Investors have no choice but to care about how and why tax changes will impact their current holdings and how the changes will impact the markets in the months and years ahead. The president was elected one year ago now. His economic and regulatory plans have helped to add support under the equity markets, hence the so-called Trump bump and the Trump rally referenced by the financial press. Here is how the broad market indexes and exchange traded funds have risen from a year ago and year to date, as of November 8, 2017:
There are some obvious issues and risks when it comes to predicting how tax reform (or tax cuts) will play out. Lobbyists have yet to make their marks, and everyone should never underestimate the power of special interest groups trying to get their way. Some of these expected outcomes could even change radically, which means that some of the expected outcomes might even come with a reverse-course over what was initially intended.
24/7 Wall St. took numerous views of proposed tax changes as they stand the first week of November. Lawmakers are already targeting some changes, and various mark-up efforts in the House and Senate have yet to be telegraphed to the public. However tax reform comes, it can impact stock market sectors, it can impact classes of investors, it can impact Treasury yields and other debt yields, it can impact dividends and buybacks, and so on.
Here are 10 areas of tax reform that may change handily for the investment community.
1. Corporate Tax Rate Cuts
There is a large debate between parties over whether corporate tax rates dropping from 35% to 20% (or even 25%) will create jobs. There is also still a debate whether the savings will really turn into more jobs. U.S. companies are without argument taxed at much higher nominal rates than almost all OECD nations. If the business climate improves further and is expected to remain pro-business for years ahead, it would make sense that companies will reinvest in their businesses and would hire more people. Still, this debate continues on.
What would seem to be obvious is that the extra after-tax cash, even if it is used for the greater good as well, will be sent back to investors. The direct issue will be more money for dividends and more money for stock buybacks. If that holds true, it translates to higher stock prices if all other issues remain static. It also will generate more cash for mergers and acquisitions, which generates better returns for investors who own companies being acquired.
Moody’s recently showed the impact that past tax reform efforts had in different sectors and their stocks.
U.S. corporations have massive amounts of cash that is kept overseas. Some Americans feel it is corporate tax evasion, and others feel it is to avoid a double-taxation penalty at the 35% rate that other OECD nations do not have. Either way, how much money will come back into the United States will depend on what the actual repatriation rate will be. Let’s just say the 12% proposed rate, or something close to it, holds true.
Repatriation of foreign cash will have several impacts that overlap with lower tax rates above. This will translate to more domestic cash that can be used for higher dividends and buybacks and for mergers. That’s obvious.
Where the foreign cash being repatriated will matter is that it is likely to keep companies from having to issue domestic debt rather than to pay the current repatriation penalty. Companies like Apple, Intel, Microsoft and a host of others have seen their levels of long-term corporate debt explode higher (some exponentially) from before 2012 through 2016. This likely will lower the need for many top companies to borrow less ahead, and that repatriated cash might be used to pay down that long-term corporate debt. This means less investment-grade corporate debt issuance, which means that debt investors will have to look elsewhere for their “safe investing money” to go outside of stocks.
3. Municipal Bonds
Investors have been serious about owning tax-free municipal bonds in recent years. After all, these are not taxed at the federal level and they are in many cases not taxed at the state income level. Tax reform is set to eliminate the tax-free characteristics of certain types of new issuances. Unless there are some changes that block this effort, there likely would be fewer issuances of all sorts of municipal bonds. There are currently expectations that the tax-free status for certain health care institutions and hospitals will end. Also losing their tax-free status might be pointing to certain types of housing, higher education, infrastructure and even refunding bonds. This should be viewed as “some” rather than “all.”
What this means for investors is rather complex, but investors in higher tax brackets are already attracted to the tax-free interest from coupon payments. If you have a tax rate of 39.6% plus have exposure to state income taxes, your after-tax effective rate just generates better returns on a dollar-for-dollar comparison than if you are taxed at 25% or lower.
On top of the demand remaining high for tax-free bonds, there is likely to be a lower supply of bonds that are truly tax-free. With simple supply and demand pressures as a guide, a lower supply of tax-free bonds will mean that a larger number of investors will bid up the prices and therefore drive down the tax-free yields. This means tax-free investing becomes harder with lower yields, and that means that certain investors may become locked-out of investing in the tax-free muni-bond market. Proof: Thomson Reuters recently showed how the AAA rated 30-year municipal index yield fell 22 basis points in the days after the tax plan was unveiled.
4. Retirement Planning
Over the years there have been efforts from both Democrats and Republicans to lower the limit of what can be used for retirement investing in traditional 401(k), IRA variations and other defined contribution plans. This was debated in recent years, and the first suggestion in the Republican tax bill in 2017 was that limits may be coming for what is deductible for 401(k) and retirement investments. While this appears to have been, moved to the sidelines, and while the president was adamant in not limiting retirement savings, investors should know that this is still up for debate in some form.
And most importantly, there are also no assurances that the attack on retirement savings will not be picked up in the years ahead, even if things look favorable today.
5. Lowering the Pass-Through Tax Rates
This has become another political hot potato that is widely debated, but taking the tax rate on pass-through payments will quite simply give owners the same choice as companies with repatriation or lower corporate tax rates — they can invest more into their businesses or they have more money to invest on their own. There are currently some “anti-abuse rules” that prevent the actual pass-through rate debate alive and well, and until this assigned into law it is nearly impossible to predict a formal outcome.
While a formal number cannot be predicted, even if it does not apply to an income test or other exclusion, this does aim to lower K-1 and related income taxes in some cases. This likely will help investing sectors such as master limited partnerships (MLPs), but there have been mixed views on this of late, even as MLP funds and ETFs have rallied over 5% in the past two weeks.
6. Impact of Mortgage Interest and Local Tax Caps and Reductions
The Republican tax bill has decided to sacrifice certain amounts for deductions of mortgage interest from the primary residence. This is to help pay for corporate tax cuts with higher tax revenue as it stands now. Whether this gets enacted after the lobbyists get in the door remains to be seen, but the current proposed changes are as follows: mortgage interest deduction remains, but with a cap of $500,000 of principal on newly purchased homes, and state and local property taxes may be capped at $10,000.
Depending on how property taxes are ultimately treated, this looks to target higher earners due to it applying to higher property priced-homes. This could have an impact on mortgage-backed securities and the mutual funds and ETFs that invest in them. There could be higher demand for the “conforming” (Fannie Mae and Freddie Mac) mortgage pools, and it may make the spreads wider for the non-conforming (jumbo) loans. Another area that could be affected is the homebuilder stocks, many of which initially fell after the limitations were shown.
7. The Impact of More Federal Deficits
There remains a debate over how much the tax cuts and reform plans will affect the federal budget deficits. The Tax Foundation issued a fully enacted federal revenue target of $1.98 trillion over the next decade, on a static basis and using a current law baseline. Again, the net effect simply will not be known until it is seen in time and after the dynamic scoring is proven or disproven. For argument’s sake, let’s see what happens if the deficit is increased by $1 trillion and also by $3 trillion.
Unless the United States begins seizing assets internally and externally to pay for the deficits, investors need to understand that this means more Treasury notes and bonds being issued to finance the deficits. If it is an additional deficit of $1 trillion, then it’s only $100 billion more in Treasury issuance per year for a decade. If it is $3 trillion, then the Treasury has to issue an additional $300 billion in Treasury debt per year. One is easy enough to absorb, one is not. If there is a much higher issuance of Treasury debt, and if all other things remain static, that is more supply and that would translate to higher interest rates if domestic and international investors cannot or will not absorb the additional Treasury debt.
8. Junk Bond Issuers Could Feel Pressure
Yet again, another issue in the future tax code might be up for change or negotiation. The initial tax reform aimed to target certain interest deductions against corporate income taxes. This would mean that companies with high debt levels get to deduct lower interest amounts against their income. According to the Tax Foundation, net interest expense on future loans would be limited to 30% of earnings (actually EBITDA) for businesses with gross receipts of $25 million or more.
If companies have disadvantages from being junk bond issuers, then this will mean a lower supply of junk bonds in general. Traditional laws of supply and demand would indicate that a lower supply of junk bonds means they become more expensive and yield less than they would have otherwise. At the same time, what if investors were to just shun the junk market at anything close to current rates based on a lack of viability for companies drowning in debt? You won’t know how lower interest deductions really affect the junk bond market until you see it.
Fitch Ratings tried to outline how tax reform could put speculative grade (junk bonds) issuers at risk.
9. Operating Losses and Carryforwards
The Republican tax plan initially aimed to restrict the deduction of net operating losses to 90% of net taxable income. At the same time, the Tax Foundation noted that it allows net operating losses to be carried forward indefinitely and increased by a factor reflecting inflation and the real return to capital. The Tax Foundation also suggested that the effort eliminates net operating loss carrybacks. If you got lost there, you are not alone.
When it comes to altering how net operating loss (NOLs) carryforwards are treated in corporate taxes, two sectors that have a huge interest here are biotech and technology. Some emerging pharma companies spend literally hundreds of millions of dollars (or more) to get their first big drug to market, so if the company gets to deduct less against future earnings then it impacts their future tax rates. Many technology companies also operate at losses for years, so any changes in NOL carryforwards could affect the newer technology companies in the years ahead. How investors interpret this outcome could go either way, and we are not willing to predict an outcome here when also trying to consider lower corporate tax rates.
10. Carried Interest for Private Equity and Hedge Funds
The debate over carried interest continues. If the masses know one thing, it is that taxation on carried interest almost never applies to them, but it does apply to millionaires and billionaires running hedge funds and private equity funds. Carried interest pertains to how hedge funds and private equity funds are taxed, either as long-term capital gains or at the higher income tax rates.
Despite strong earnings from some key private equity firms, their stocks (or units) have not been as strong as the market in general. There is some obvious fear here if private equity managers (and their investors), who by and large target longer-term gains, are taxed entirely as income. How this turns out remains to be seen, but it could have an impact on how active buyout firms and investment firms look at their investing.
Hedge fund managers might have even more at risk than private equity funds when it comes to carried interest. Some hedge funds are long-term investors, while others tend to invest more like day traders and swing traders, looking for short-term gains from market disparity and opportunities. If hedge fund managers have to face higher taxes, they may take less risk and they may trade less. That can lower liquidity and can lower trading volume on the exchanges.
TheStreet.com showed how the changes in carried interest taxing might help private firms and hurt hedge funds on a relative basis.
A final note here for investors and market watchers alike: It is easy to see how some changes in tax laws will affect investors. In other instances, it is far more difficult to know how tax reform or tax cuts will spill over. As of November 8, 2017, these all remain up for grabs and may change handily in the coming days or weeks.
Choosing the right (or wrong) time to claim Social Security can dramatically change your retirement. So, before making one of the biggest decisions of your financial life, it’s a smart idea to get an extra set of eyes on your complete financial situation.
A financial advisor can help you decide the right Social Security option for you and your family. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you.
Click here to match with up to 3 financial pros who would be excited to help you optimize your Social Security outcomes.
Thank you for reading! Have some feedback for us?
Contact the 24/7 Wall St. editorial team.