Stock Values and Corporate Tax Reform

By: Dave Perkins, J.D., CPA, CFP^® and Dustin Barr, CFA

Some analysts forecast that earnings of S&P 500 companies could increase as much as 18% in 2017 over their 2016 levels. (Morgan Stanley, “Buy the Election, Sell the Inauguration”, 1/11/17)  Nearly half of that increase comes from the assumption that corporate tax rates will drop substantially in 2017. After all, if a company’s taxes rate drop from 35% to 20%, that 15% savings would result in additional corporate profit, all else being equal. The U.S. has not had a permanent change to the corporate  tax rate since the Reagan Administration.  At that time, the 35% tax rate was one of the lowest in the world.  In the 1980s, corporate tax reform took Congress more than 2 years to pass.  While it seems likely that a tax reform bill will become law this year, there is a possibility that the reform and impacts to the new law won’t have a big impact until 2018 or beyond.  So what are some of the changes being proposed to reform the corporate tax rules?

Three main ideas have been floated as either campaign promises or proposals from Congress. The first is simply reducing the tax rate from 35% to 20% (or 15% under different proposals). Since this would cause a significant loss of government tax revenue, deductions and credits would need to be eliminated. One is to eliminate the deduction by companies for interest on their bonds, which could dramatically change the mix between bonds and stocks that companies use, and that is where lobbying and details would get difficult.

The second idea is called repatriation, or bringing back money that companies hold overseas. Currently, companies don’t pay U.S. tax on profits they earn overseas if they keep that money for future reinvestment. They do pay tax in that foreign country, and the average overseas rate is 25% (the U.S.’s 35% corporate tax rate is among the highest in the world, however the US offers more deductions than most countries and as a result the average corporation pays a tax rate of approximately 28%; which is still higher than average global tax rates). (JP Morgan, Charts on the Market, Slide 7, 12/31/16). If a company brings the money back to the U.S., they would pay the difference between the U.S. 35% rate and what they paid overseas, on average about 10%. The repatriation proposal suggests a tax holiday that would let companies pay zero on funds that are now brought back to the U.S.

The third idea would change the way companies are taxed in an effort to eliminate the incentive to shift profits overseas and force companies to produce more goods in the U.S. This is known as a “border-adjustment system”, which favors exports over imports. For example, if Ford produces the chassis and parts for a Ford Focus in its Mexican factory, and then pays that foreign subsidiary for those goods, it currently is allowed to deduct those costs from its U.S. profit, reducing its taxes. The new proposal would eliminate any deduction for imported goods, effectively imposing a “border tariff” and increasing a company’s U.S. tax. Most major retailers, such as Walmart, buy products made more cheaply overseas and pass those savings on to the U.S. consumer in the form of lower prices. Now they would get no deduction for what accountants call their cost of goods sold.  In this scenario, lower margin retailers could see significant tax increases even if the statutory corporate tax rate fell from 35% to 20%.

How a retailer such as Walmart would respond is part of the unforeseeable consequences of making major changes in the structure of the tax code. If they pay higher taxes, what would happen to their employees and customers? If Ford in the example above produced the Focus entirely in the U.S., it might employ more U.S. workers and pay lower U.S. taxes, but the overall cost of the car could be much higher. Goldman Sachs lists apparel as the sector with the highest net imports, and therefore most likely to be harmed by the border tax, followed by autos, computers, electrical equipment, primary metals and U.S toy and game makers (95% of Hasbro’s and Mattel’s toys are made overseas) (Wall Street Journal, “Toy Makers Gird for Tax Code Changes”, 1/11/17).

One way or another, 2017 should prove to be an interesting year for taxes and their impact on corporate profits and the stock market.

Dave Perkins is a Consultant & Financial Planner with Carolinas Investment Consulting.  He has 30 years of practical, detailed financial experience in the objective advice business, having worked variously as an attorney, CPA, Certified Financial Planner™, and Fee-Based Investment Consultant. Click here to learn more about how Dave can help you.   David A. Perkins, CPA is a licensed North Carolina CPA firm. Although Dave provides his financial planning and investment consulting services through Carolinas Investment Consulting, it is a separate business from his CPA practice and bears no legal responsibility for tax advice provided by Dave in his capacity as a CPA.

Dustin Barr, CFA is a Consultant & Director of Research at Carolinas Investment Consulting. He oversees the CIC Investment Committee and manager research and due diligence process at the firm.  He provides investment & financial advice to families, non-profits, and corporate retirement plans.  Click here to learn more about Dustin and how he can help you.  

The information published herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. All information, views, opinions and estimates are subject to change or correction without notice. Nothing contained herein constitutes financial, legal, tax, or other advice. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit to your financial status, risk and return preferences. Investment recommendations may change and readers are urged to check with their investment advisors before making any investment decisions. Information provided is based on public information, by sources believed to be reliable but we cannot attest to its accuracy. Estimates of future performance are based on assumptions that may not be realized. Past performance is not necessarily indicative of future returns.