Congressional approval of a sweeping tax bill provided President Donald Trump with his first significant legislative victory. According to Trump, “this is going to be one of the great gifts to the middle income people of this country that they’ve ever gotten for Christmas.”
Senate Minority Leader Charles Schumer had a contrary view, labeling the bill as a “hefty windfall for the wealthy and only [a] paltry temporary leap for some in the middle class.” As is so often the case in this polarized political environment, the truth probably lies somewhere in between Trump and Schumer’s points of view. The nearly 1,100 page tax bill has major implications for corporations and individuals, but falls short of the simplification promised earlier in the legislative process.
Despite claims from Trump and Treasury Secretary Steve Mnuchin that the tax bill would provide a sustainable and significant boost to economic growth, most private sector economists expect a more modest impact. In the words of one economist, the bill is more “carbs than protein,” and will provide a near-term boost to economic growth but not be a catalyst for a new paradigm for growth.
As was the case when taxes were cut during the Ronald Reagan and George W. Bush presidencies, incremental growth isn’t likely to fully offset the cost of tax cuts. Consequently, the federal debt will rise. Although the budget deficit may not rise by a significant amount, long-term issues surrounding entitlements such as Medicare and Social Security continue to be unaddressed.
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Reduction of the maximum corporate tax rate from 35 percent to 21 percent and elimination of the corporate alternative minimum tax will provide significant benefits to many corporations. The U.S. will move from being having one of the highest corporate tax burdens in the world to being in the middle of the pack.
Small company stocks, many of which pay close to the statutory maximum tax rate, will get a significant earnings boost. Although the benefit of the tax cut is already partially factored into small company stock prices, the small stock rally may continue into 2018. Certain industries will also benefit from lower tax rates, most notably retailers, financial services companies, health insurers, telecommunications providers and energy refiners.
The tax bill moves toward a territorial tax system, taxing companies on profits earned in the U.S. It also provides incentives for companies to repatriate overseas profits from prior years back to the U.S. The positive impact of repatriation primarily will help a small number of companies.
Technology companies including Apple (Nasdaq: AAPL), Microsoft Corp. ( MSFT) and Oracle Corp. ( ORCL), pharmaceutical/biotechnology companies and a couple of major banks are the primary beneficiaries of the repatriation provision. The small number of companies with meaningful overseas cash balances are more likely to pay down debt, buy back stock, or raise dividends than to dramatically increase capital expenditures or add materially to their U.S.-based workforce.
Telecommunication providers will be among the companies that benefit from the ability to immediately expense capital investments, but in many cases the new tax rules will pull forward spending that was already planned rather than create a lot of new spending. Highly leveraged companies will be hurt by provisions that limit interest deductibility, though real estate firms and utilities were granted exemptions to those provisions of the new tax code.
Changes to taxation of pass-through organizations such as LLCs and S corporations are among the most complex aspects of the tax bill. Pass-through entities will receive favorable tax treatment, helping manufacturing and real estate organizations, however, law firms, medical practices, consultants and investment managers are among the entities that won’t be able to take advantage of the beneficial tax treatment of pass-through income.
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Personal tax code changes have far-reaching implications, despite being scheduled to expire in 2026. Consumer spending will get a near-term boost, as the majority of taxpayers should benefit from reduced taxes. Longer-term, however, the impact on consumers will be more ambiguous as provisions expire and inflation adjustments become less generous.
The increase in the standard deduction will limit the number of households that choose to itemize deductions, which will reduce the financial incentive to buy a home rather than rent. Expensive real estate markets in high tax states such as California, New York, New Jersey, Connecticut and Massachusetts will see declining demand as a consequence of caps on mortgage interest deductibility and severe reductions in the deductibility of state and local taxes. Reduced supply of homes for sale in those markets may provide a partial offset for the demand loss, as current homeowners may be less likely to sell given the tax changes.
The end of the federal penalty for failing to have health insurance means that fewer healthy people will buy insurance and that more uninsured people will seek treatment from hospitals. Insurers and hospitals will bear the brunt of the elimination of the unpopular individual mandate, though it also likely that consumers and corporate insurance buyers will face higher prices, higher deductibles and more restrictive insurance options.
The near-term boost and front-end loading of economic growth from tax cuts raises the odds that the U.S. economy will overheat, making it likely that interest rates will rise at a more rapid rate in 2018 and 2019. The front-loaded benefits will likely fade absent structural changes in the supply-side of the U.S. economy. The economy may still struggle to achieve long-term growth of more than 2 percent, given the constraints of debt, deficit and demographic challenges.
The durability of the tax bill may also be a relevant issue. The bill passed without any Democratic votes, there will be big winners and big losers resulting from the complex bill, and the potential for unintended consequences is quite high. The combination of these three factors makes a renewed battle over taxes likely whenever the Democratic Party returns to power.
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How the Tax Plan Affects Investments originally appeared on usnews.com
