How Tax Reform Could Impact Portfolios
Stocks continue to rally while no major legislative accomplishments come out of Washington D.C. Markets prefer gridlock over sweeping policy changes, particularly changes that affect property rights, so this is no surprise. Really, the fact that no major legislation has passed is a positive economic event in and of itself.
However, the calculus changes when it comes to tax reform as compromise could occur in this area. If so, major winners could emerge with a streamlined tax code that lowers effective tax rates for most individuals and corporations.
Tax reform is still a big “if”, but even some minor change seems more likely than not. In preparation, investors might consider screening their portfolios and the market for sectors and companies that could benefit from lower rates. This is something we do for clients using our databases, software, models and unbiased research powered by Zacks Investment Research.
A Quick Look at Proposed Changes
This column focuses on how tax reform could impact corporate America, so we’ll look at proposed corporate tax code changes. Here’s a quick summary of what’s on the table:
- Drop the top rate for small businesses to 25% (currently small businesses are generally taxed at the individual level)
- Lower the corporate tax rate from 35% to 20%
- Repeal the corporate alternative minimum tax
- As an incentive to increase business investment, allow businesses to immediately write off the cost of new investments over five years
- Partially limit interest deductibility
- Keep the research and development tax credit, along with the low-income housing credit
Who Might Benefit?
Let’s focus on the lower corporate tax rate. If that were to pass, we could technically screen companies based on their effective tax rates. If we did that, we would take a close look at those companies with the highest rates, as they would arguably benefit most from a cut.
Another beneficiary could be small-cap indexes, for a couple of reasons. First, regional and small banks make up a significant percentage of domestic small-cap indexes, and tend to have high average tax rates. Second, small-cap stocks tend to be more domestic-oriented companies, meaning they generate a higher share of their revenues in the U.S. versus abroad. It follows that since last year’s Presidential election, a basket of high tax banks has outperformed the S&P 500.
Companies with large shares of profits overseas could also see a major benefit from tax reform, assuming a repatriation clause is included in the new law (providing incentive to move some overseas profits back to the U.S.). This would knock out their tax liability and provide an influx of cash for buybacks, dividends, and/or capital expenditures which could boost shares.
Bottom Line for Your Clients
There is largely a consensus among Republicans on the need for tax reform, but how to accomplish it is a different story. For example, the original House Republican plan called for using a border adjustment tax to generate revenue needed to finance lower rates for other sectors. Many Republicans and analysts viewed this favorably, but the idea was essentially nixed by two Senators from Arkansas (the home state of Walmart). The point is: tax reform is more complicated than most think, and the process could get ugly.
That being said, we believe there is a relatively strong possibility of some law passing, so it could make sense for investors to position their portfolios accordingly.
This original article was sent to us by Mitch Zacks.
Mitch is a Senior Portfolio Manager at Zacks Investment Management and has published two books on quantitative investment strategies. Mitch has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.
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