The federal tax law overhaul signed by President Trump at the end of last year, totaling more than 800 pages, marked the first comprehensive change to the U.S. corporate and personal tax systems since 1986.
In broad strokes, the biggest changes include:
- Permanently reducing the corporate tax rate from 35 to 21 percent
- Temporarily reducing personal tax rates
- Doubling the standard deduction
- Restricting the deductibility of state and local taxes from federal taxes
- Limiting the deductibility of interest costs
- Encouraging the repatriation of foreign earnings
The details of the changes were not disclosed in the process of the bill’s assembly, even to many of the legislators in the Congress, and will emerge in the coming weeks and months.
The impact on the capital markets will be mixed. The lower corporate tax rate will clearly boost earnings for U.S.-based companies, and the disproportionate benefit will accrue to those whose businesses are focused on the U.S. market. The stock market may have already priced in much of this benefit, however, in the bidding up of stock prices during 2017. Initial estimates show a one-time bump in earnings growth of 6%-8%, which would lower price/earnings ratios for the stock market and thereby justify some of the price run-up during this past year.
The impact on the economy is expected to be modest at first, with initial estimates of a quarter to a half percent increase in GDP growth for the U.S. in 2018, bringing GDP growth up from 2.25-2.5% to closer to 3%. The longer-term expected boost from the tax cuts offered by the framers of the legislation are both further out on the horizon and subject to more controversy. The benefit will depend in part on the actions taken by businesses: whether the tax reductions will be spent on capital expansion and jobs, on stock buybacks, or on price reductions in the face of global competition.
The impact on the debt market is also of great interest (pardon the pun). The tax cuts and other provisions in the code such as the restrictions on interest cost deductibility could reduce the supply of corporate debt and drive up bond prices, thereby holding down interest rates. Interest deductibility could also impact investment strategies that rely heavily on debt such as private equity.
Callan will examine the details of the law, and review the analysis by others in the investment management and asset owner communities, and report on our interpretation of the tax law and the changes wrought as the coming weeks unfold. We will be particularly interested in exploring the differing impact of the tax law change on defined contribution plans, corporate defined benefit (DB) plans, public DB plans, endowments, foundations, and taxable pools.
