INSIGHTS

On February 08, 2017

The “I’s” Have It Series – Income Taxes

One large expectation with the new administration is the cut in individual and corporate income taxes. Now that we are roughly three weeks into the new administration, there are already those who are clamoring for the details of the policy while the new administration is extending the period with which they are saying a new policy may come into action. This is neither unique nor unexpected to the neutral observer…it is politics as usual. The challenge to be fair is the distinction of tax cuts and tax reforms. Tax cuts can be fairly easy to implement, however, the tax reform is much more challenging issue when many will be clamoring for a revenue neutral model to not increase the budget deficit.

Our expectation is the tax relief package will resemble the one we saw in 2001. The top-end marginal rate of 39.6% could potentially be dropping back to the pre-tax expiration of 35% from the original plan in 2001 and ultimately ended at 2012. There are two basic proposals floating around, one from the House Republicans and one from President Trump. Both are similar in nature but do have some distinctive differences. We will pinpoint some of those as we get a better indication of when and what the tax reform looks like.

The issue of tax reform relative to cuts is probably going to see more on the tax cuts as they make better headlines. Potential tax cuts of $200 billion net should add roughly 0.5% of GDP boost once implemented. It could be bigger assuming some multiplier impact with rising sentiment and therefore consumption. One thing that is apparent that this expansion hasn’t addressed is the uplifting of the vast majority of the economy. In 1989 the average net worth of a U.S. citizen was $342,000; the median was $85,000. It peaked in 2007 with the average at $625,000 and median of $136,000. The last Fed data from 2013 showed the average was $529,000 and the median was $81,400; lower than 1989.

Just as Individual tax rates are primed for reductions, so too is the corporate tax code. The all-in U.S. corporate tax rate stands at 39% with its next closest country being France at 34%. The OECD (Organization for Economic Co-operation and Development) top 20 average right at 24%, which is where the House Republican proposed rate would fall. The issue at the end of the day is the net effective rate. It is estimated the U.S. individual effective tax rate equates to 25% in total; corporate effective tax rate is around 27%. For the next year the enthusiasm for massive cuts and simplifying the codes will likely only partially succeed. Some cuts in the rates will be present but removal of deductions for both corporations and individuals is likely the end result. Best estimates is potentially a 22-25% marginal corporate tax rate with effective rate approaching 25%. The Repatriation could be an estimated one-time 10% tax rate for an estimated range of $1 to $2 trillion total estimated cash holdings for all U.S. companies abroad. I wouldn’t expect it all to come over but taking $1.2 trillion at 10% adds $120 billion to government coffers (it would actually be calculated at a loss because assumption was at the higher rate that this would be coming over). That would leave roughly $1.08 trillion net to corporate coffers, but would not be likely to solely go into the business or new activity (as companies have been flush with cash for years and have used it primarily for stock buybacks).

The impact of the repatriation would seem to only amplify current patterns of capital expenditures and return of money to shareholders. Consider that we have been averaging $138 billion per quarter in stock buybacks since 2012, bringing stock supply off the books.

If you’re bearish, this would be a sign that a market correction is eminent as through the 3^rd quarter of 2016 we have seen declines in stock buybacks. However, consider that we have been reducing supply of stock for some time which mitigates the magnitude of a correction. A correction of 1-3% would be healthy at this point, but there are some basic supply demand functions that could reduce the decline.

Net new IPOs (Initial Public Offerings) have totaled roughly $19 billion in 2016; in the last decade we have raised $450 billion in IPO proceeds in the United States. There has been $612 billion in stock buybacks in the last four quarters alone, with the 3^rd quarter of 2016 coming in at one of the lowest rates in four years at $113.5 billion. The results for the 4^th quarter will be lower as it appears now, however, that there is a significant lag in getting all the numbers tallied. If we do see the $1.2 trillion in repatriation, the net $1.08 trillion to companies likely won’t be spent entirely on buybacks, but it likely will be pronounced and could artificially increase the EPS (Earnings Per Share) and assist in the multiples.

To put this in perspective, if we see a potential buyback of $800 billion (as measured in S&P 500 which has bought $527 billion back in the last complete four quarters), you could be pulling off roughly 3.9% of the market cap. Based on expectations of $123 in earnings per share, one could argue that the surge in buybacks may increase earnings per share of roughly 4.92 by itself. That difference at an 18 multiple adds nearly 90 points to the S&P 500, without adding in economic boost and potential tax cuts increasing their profit margins.

One key figure as to why this won’t be all stock buybacks is the shift in fund managers’ desires for what companies to do with their cash. In one of our favorite monthly publications, Bank of America Merrill Lynch produced their Global Fund Manager Survey. The most recent survey confirmed – once again – the shift in fund managers’ wishes for companies and the utilization of their cash.

As you can see in the chart above, the desire for increased capital spending is nearly three times their desire to have cash returned to shareholders or improve their balance sheets. As they note in their comments, the recent level of increased capital spending is at 2.5-year highs.

Once the changes are implemented on tax reform, both individuals and corporations should begin to see a boost in confidence and, therefore, consumption and investment.

CRN: 2017-0201-5782 R

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