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The US president has just announced its eagerly awaited tax reform. Since American stocks have become very expensive, we have focused on what could impact the earnings of listed companies. Given the importance of Wall Street for the other market places, this is more than just an US issue. At first glance, lowering corporate taxes from 35% to 20% should boost profits. Yet with the effective tax rate for listed companies so far from the theoretical rate, the reality is not nearly so black and white. Plus, we are seeing major disparities, according to business sector, the share of international sales or the size of the companies. Against this backdrop, generalisations can be misleading. Ultimately only four out of ten sectors should benefit from the lower corporate tax rate. On the other hand, domestic stocks and small- and mid-caps should do very nicely.
A “historic” plan
On 27 September the US president outlined his tax reform, calling it historic. It includes three components: household tax rates, corporate tax rates, and repatriation of foreign profits. At this stage, it is only a bill and will have to get through Congress to become law. Given his crushing defeat with the repeal of Obamacare, President Trump should make every effort to make his plan a reality.
The consequences can be approached from multiple angles: impacts on consumer purchasing power, business investment, GDP growth, deficits, etc. For this article, we’ll focus more specifically on the impacts for listed companies’ profits. US equities are indeed so pricey that this reform – which would likely pump up profits – was eagerly awaited by Wall Street. In the Q&A session of the paper other in-house specialists will briefly draw the main features of the bill, estimate its potential impact on GDP and consider its possible impact on financial markets1. The repatriation of liquidity is also an important aspect of the reform. This should mainly concern the multinationals, notably in the tech sector, which should boost their buyback if it was to happen. But at this stage, given the lack of details, it is too early to elaborate much further.
From principle to reality
As to corporate tax, this plan would cut federal taxes from 35% to 20%. All other things being equal, this would mean that companies paying taxes at the full rate should see their earnings jump +23%. However, between principle and reality, there are many grey areas, even surprises.
For example, we can see that the effective corporate tax rate was already well below the theoretical rate. On top of that, there are major tax disparities from one compartment of the list to the other, according to sector of activity, size of the company, and degree of globalisation. Beyond these general findings, the impacts of such a reform must, of course, be judged according to each company’s specific characteristics. Going by two relatively close companies – Morgan Stanley and Citigroup – the CEO of the first said in a conference last June2 that, all other things being equal, if its corporate tax rate fell to 25%, its earnings would go up by 15%, whereas for Citigroup, the impact would be just 5%. In some cases, the corporate tax cut might even be costly! That’s true for companies that have accumulated deferred tax credits during the crisis. For example, at the end of 2016, there were $7 billion in US eligible deferred tax credits on Bank of America’s balance sheet, but now, those will have to be depreciated by $3 billion to factor in the corporate tax cut.
A theoretical US tax rate so far well above that of the other MSCI World member countries…
Graph 1 below compares 2017 theoretical corporate tax rates in the 20 main countries in the MSCI World AC (96% of the index’s total capitalisation). Where applicable, these rates calculated by KPMG combine different national and local taxes. Thus, in the United States, local taxes averaging 5% are added to the 35% federal rate, for an overall rate of 40%. This 40% rate was the highest in the sample. Yet, assuming the reform results in unchanged local taxes, the American theoretical corporate tax would drop - all other things being equal - from 40% today (35% + 5%) to 25% tomorrow (20% + 5%), which would place it a) near the median of the sample and b) end up inflating earnings by 25%!
…but a yawning gap between theory and reality!
At first glance, this looks like a massive cut. Yet in reality, beyond the theoretical rate, we should look at the effective tax pressure of American stocks. Graph 2 tells us that the median corporate tax rate of the MSCI USA Index was just 24% in 2016 (and 25% on average from 2007 to 2016) instead of 40% in theory! So, the reality is plainer than it looks. Anyway, in some cases, the effects of the theoretical corporate tax cut from 40% to 25% will be far from negligible. To fully understand these effects, we will highlight three major factors: sector, location, and size.
The sectoral factor. Graph 3 below3 shows that, on average, from 2007 to 2016, half of the sectors in the MSCI USA had an effective corporate tax rate above 25%, with Telecom (40%) at the top.
To sum up, four sectors (in green above) seem especially well placed to benefit from the announced corporate tax cut: Telecom, Healthcare, Consumer Staples, and Consumer Discretionary. Three other sectors (orange), Industry, Energy, and Base Materials, should also benefit, but to a lesser extent. Finally, each of the last three (dark blue) – Utilities, IT, and Financials – is a special case which we will revisit.
The geographical mix factor. With few exceptions, like Utilities and Financials, there is apparently a powerful relationship between sales percentage in the US and the tax pressure rate. Thus, the more globalised a sector is, the lower its tax pressure. The perfect example that has people talking right now is the IT sector. The sector’s giants like Google, Apple, Facebook and Microsoft are known to be undertaxed, particularly beyond their borders.
Yet Amazon, which is often lumped into the GAFAM group with the previous four companies, does not belong to the IT sector but to Consumer Discretionary - Internet Distribution, just like Netflix or TripAdvisor. In addition, for the moment at least, Amazon is less international (34% of revenue compared to an average of 55% for the other four) and taxed at a higher rate than the other GAFAM companies (37% corporate tax vs. 18% on average).
As for Utilities, the sector is highly domestic (95%) and yet pays low taxes. In this case, the explanation is found in the tax base; in consideration for their regulated earnings, they had, until now, broad deduction options. And finally, for the Financials, while their average corporate tax rate for the 2007-2016 period was very low (6%), this reflects the damage to their profitability at the start of the Great Financial Crisis (2008-2009) and the generation of significant deferred tax credits since then.
The size factor. Graph 5 compares the corporate tax of the MSCI USA and MSCI USA Mid Cap indices. Overall, the median corporate tax rate on mid-cap stocks is seven points higher than for large-cap stocks. Furthermore, when sectoral information is available, we find that in five out of seven cases, the corporate tax rate on mid-caps is well above that of the blue-chips. Healthcare and Staples, where tax rate is close, being two exceptions.
Only time will tell whether the announced tax return will make it through Congress. If the key points of the plan are upheld, the impact on listed company earnings would be more limited than it appears, given the massive gap between the theoretical corporate tax rate (40% including local taxes) and the effective rate (25% on average from 2007 to 2016). Among the large-caps, four out of ten sectors – Telecom, Healthcare, Consumer Discretionary, and Consumer Staples – should benefit from the projected corporate tax cut. Likewise, domestic stocks and small- and mid-caps should also reap substantial rewards.
1 See Q&A below
Q&A on the US tax reform
1. Introduction, rationale. By Paresh Upadhyaya, Director of Currency Strategy, US
On 27 September, the Trump administration and the Congressional Republican Leaders released the “framework”, which should lay the foundations for the new tax reform. The goal of the reform is to simplify the tax code, boost investment and consumption and make the US corporate tax rate more competitive with the rest of the world.
While the details remain somewhat vague, the Framework calls for a reduction in the corporate tax rate from 35% to 20%, limits the top tax rate applied to pass-through business income to 25%, and introduces measures to promote the repatriation of profits and prevent US companies from shifting profits to tax havens.
For individuals, the framework also would reduce the current seven individual tax brackets to three, with rates set at 12%, 25%, and 35% (income ranges to which the rates would be applied are not detailed yet), while leaving open the possibility of providing a fourth higher tax bracket for upper-income individuals.
The legislative process to pass the bill is long. In addition, given the complexity of the tax issue and the demands from various lobbying and politicians, the final tax plan is going to change.
Timetable of Tax Plan
2. How would you assess the effect of the tax reform on US GDP? By Annalisa Usardi, Strategy and Economic Research
Given the uncertainty still surrounding the final definition of the tax reform bill, it is difficult to evaluate the impact of tax reform on our GDP projections. There is a myriad of literature concerning the estimation of the fiscal multiplier, stressing the higher impact on growth from direct fiscal stimulus coming from increased government expenditure compared to tax reform, and highlighting the different impact of the same reform depending on the business cycle phase.
With regards to the short-term impact, the CBO took into account a wide range of literature and models and provided aggregated estimates of fiscal multipliers applicable to the US economy. By applying this framework to our current estimates for GDP growth in 2018 and assuming that in Q1 2018 a reform is delivered, we obtain a boost on our 2018 estimates ranging from +0.1% (low multiplier effect) to +0.45% (high multiplier) on top of our base case. We get similar results (+0.4% on the 2018 yoy projections) from using a BVar model, where we can see that the major boost to growth comes from investments (+1% on top of currently-projected yoy fixed investment growth) and, to a lesser extent, from higher consumption (+0.2% on top of yoy growth in baseline personal consumption expenditure).
3. Would you expect the reform to have an impact on potential growth over the long term? By Annalisa Usardi, Strategy and Economic Research
On the long-run impact, the lack of detail is even more troublesome if one wanted to evaluate the impact on potential growth: changes to the saving, investment, working incentives, income redistribution and impact on deficit and debt patterns induced by a tax reform could have different ways of impacting potential output depending on the way such reform is designed. From a qualitative point of view, it can be noted that an effective tax reform aimed to boost productivity, as it may be the case for the US economy, should be designed not only to free cash from Companies (something that US companies do not lack) but to create incentives to invest and increase capital intensity. Infrastructure improvements and more effective regulation could be setting a better framework where tax reform, especially on the corporate side, could spill over onto productivity. But as of now, it is difficult to evaluate how the current administration would be able to push on Infrastructure plan and changes in regulations.
4. What would you expect to be the impact on public finances? By Paresh Upadhyaya, Director of Currency Strategy, US
According to the Tax Policy Center, the tax plan would reduce federal revenue by $2.4tn over 10 years. Their analysis of the breakdown in revenues reveals that the individual income tax provision would lead to a $470bn increase in revenue over ten years, which is more than offset by the business income tax provisions that reduce revenues by $2.6tn and the elimination of estate and gift taxes that cut $240bn. The road is likely to be bumpy with many roadblocks along the way. One such roadblock in the proposed tax plan includes scrapping the deduction of local and state taxes. This is already leading to opposition by Congressional Republicans from
5. What could be the fixed income and the dollar response if the reform passes? By Paresh Upadhyaya, Director of Currency Strategy, US
Given that the economic and therefore inflation impact is likely to be modest, the impact on Treasury yields should also be rather modest. However, if the final tax bill is more stimulative and adds to the deficit, Treasury yields could rise sharply as the markets price in a more aggressive Fed tightening cycle, which would also boost the US dollar. Additionally, as part of the overall corporate tax reform and possibly to fund the fiscal stimulus programme, there is a proposal for a repatriation tax holiday. The one-off tax holiday would give multinational corporations a low tax rate to repatriate offshore earnings. A similar proposal, named the Homeland Investment Act (HIA) in 2005, brought in around $300 billion (USD and non-USD). There are between $2.5 trillion to $3 trillion in earnings kept overseas. Conservatively, I believe we may see a repeat of the inflows seen in 2005. In 2005, US corporations repatriated 30% of total US earnings. If that percent holds true again, it could equate to $780 billion. As most offshore earnings are in Europe, Canada, the UK, Switzerland, Singapore, Mexico and Japan, we believe the euro, Canadian dollar, British pound, Swiss franc, Mexican peso and Japanese yen are most vulnerable to repatriation.
6. What would you expect to be the US equity market reaction to the tax bill? How much is already priced in the market? By Marco Pirondini, Head of Equities, US
There are two main aspects of the reform that, if passed, can have an impact on the market: the lower tax rate for corporates and the repatriation of foreign earnings. The first one would increase the EPS of the market by circa 10% with an obvious positive impact on valuations. The second may reduce the capital inefficiency that we have in many multinationals, with large cash balances trapped abroad with massive amounts of capital available for investments, dividends and buybacks. Eliminating the distortion of foreign earnings would also allow some major companies to initiate company splits that are expected to increase their valuation. On the individual side we do not expect major tax reductions. But still, it should have a positive impact on consumer spending.
7. What will be, in your view, the key drivers of US equities heading into year-end? By Marco Pirondini, Head of Equities, US
The market started to react to tax reform in January and will continue to do so. As we move up, the risk of tax reform not happening will grow too. For next year, tax reform is crucial but the weaker dollar seen in 2017 and the stronger global growth should also extend the US earnings cycle.
An eagerly awaited tax reform.
An effective tax rate much lower than the official one.
Flagrant disparities by sector, geo-mix, and size.
In the United States: the risks associated with financial stability outweigh the problem of low inflation.”
The ECB cannot extend “too much «the PSPP if it wants to remain roughly in line
Strategy and Economic Research at Amundi
US corporate profits declined -6.8% at annual rate in Q4 2015 vs Q3 of the same year, according to Bureau of Economy Analysis data (profits before taxes with inventory valuation adjustment).Most of this decline is due to the petroleum & coal sector, whose profit declined $124 bn, and tonet overseas profitsthat fell $6.4 bn.Domestic profits excluding petroleum and coal declined only -1.7% a.r, or $38.8bn.
CFA, Strategy and Economic Research at Amundi
As the earnings season comes to a close, the time has come to report back on what we have found. With double-digit earnings growth in all the developed regions and substantial revisions to EPS, the season came out largely as promised. Between now and the end of the year, delivering surprises will be more difficult. Against this backdrop, the eurozone, where the recovery continues and where the bases for making comparisons are favourable, should offer strong opportunities.
Strategy and Economic Research at Amundi