From Buffett to Small-Cap Stocks, the Impact of Trump's Tax Plan -- 3rd Update

By WSJ Staff Features Dow Jones Newswires

President Donald Trump unveiled a proposal to cut corporate taxes and reduce the top tax rate on pass-through businesses, including many owner-operated companies, to 15% from 39.6%.

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Here's what the change would mean for Wall Street:

Earnings

The tax plan could potentially provide a big lift to corporate earnings for publicly traded companies.

Every 1-percentage-point reduction in the effective tax rate -- what companies actually pay -- could increase expected earnings for companies in the S&P 500 by $1.34 a share, according to calculations by S&P Global Market Intelligence.

That might breathe new life into a long stock-market rally. Many investors have become worried that stocks are starting to look expensive, and tax cuts "would alleviate much of the concern about valuations," said Bruce Bittles, chief investment strategist at Robert W. Baird.

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Aaron Kuriloff

Small-Cap Stocks

Many investors expect a corporate-tax cut to boost small stocks more than shares of larger companies.

Their reasoning: Multinational companies are able to defer U.S. taxes on profits earned overseas, but many smaller firms make most of their profits on domestic sales.

Investors were counting on a tax cut when they pushed up the share prices of small stocks after the election. The Russell 2000 rose 16% in the month after Nov. 8, compared with the S&P 500's 5% gain. When prospects for the tax cut seemed to dim earlier in the year, the small-stock rally petered out.

In recent days, with reports that the Trump administration is pushing ahead again with plans to cut corporate taxes, investors have been piling into small stocks again.

Corrie Driebusch

Dollar

Dollar bulls are cautiously optimistic about the tax plan. Even though an outline released Wednesday lacked elements that were expected to boost the dollar directly, some still believe that if the plan passes in current form it would be broadly positive for the dollar.

Some Republicans lawmakers have advocated a plan that would encourage U.S. companies to repatriate overseas earnings, a provision that wasn't mentioned in the outline. That could have given the dollar a boost because companies would need to exchange foreign currencies for the dollar.

Investors betting on the dollar's rise were also disappointed that a border-tax adjustment plan, which would tax imports but not exports, was left out of the tax package. The proposal was expected to bolster the dollar by raising demand for U.S. products overseas.

Yet a big corporate-tax cut could still boost the dollar by heating up the nation's economy, investors said. Stronger growth could lead the Federal Reserve to raise rates at a faster pace, making the dollar more attractive to yield-seeking investors.

Ira Iosebashvili

Banks

Banks could get a double benefit from a tax cut. It would fatten their own bottom lines but also those of customers. If customers then invest more and spur economic growth, that could fuel more lending, further bolstering banks' profits.

One fly in the ointment, at least for some big banks: Citigroup Inc. and Bank of America Corp. are sitting on huge piles of deferred tax assets -- $46.7 billion and $19.2 billion, respectively, of credits and deductions that can be used to reduce future tax bills. The banks would likely have to write down a portion of these assets if tax rates are cut, resulting in billions of dollars in charges that reduce profits.

That would be a one-time event, though, while the gain to profits would be permanent. There will be a "permanent rise in net income," said Sanford C. Bernstein analyst John McDonald, and that is what investors will really care about.

Michael Rapoport

Foreign Earnings

The White House's plan for a territorial tax system could be a boon to companies with large international operations.

U.S. companies would pay little or no tax on future foreign earnings under the proposed territorial system. The current rules tax all corporate profits regardless of where they are earned.

About a fifth of the companies in the Russell 1000 index receive more than half of their revenue internationally, and more than half receive some revenue from abroad, according to Bespoke Investment Group data.

Together with other tax overhauls, a territorial system could boost earnings for multinational companies. Bank of America Merrill Lynch estimated earlier in the year that if the U.S. moved to a territorial tax system of no longer taxing foreign profits and the statutory tax rate were lowered to 20% from 35%, S&P 500 companies would see their per-share earnings rise 12% in 2018, all else equal.

"I like that total territorial at zero. I mean that's kind of really good," said Frank A. D'Amelio, chief financial officer at Pfizer Inc., in a January earnings call in which he discussed a plan from House Republicans that would stop taxing future foreign profits.

Another benefit for companies from reducing or doing way with taxes on future foreign earnings is that if would eliminate barriers for firms to bring foreign cash back to the U.S.

Ben Eisen

Master-limited partnerships

Master-limited partnerships stand to benefit under the Trump tax plan because investors holding these publicly traded shares could get a lower tax bill.

MLPs, which are often associated with oil-and-gas companies, pay periodic distributions to their shareholders. They don't pay any corporate-income taxes themselves.

Shareholders of MLPs pay taxes on the income they receive at a rate of up to 39.6%, though they can defer paying taxes until they sell their shares. Because MLPs are pass-through businesses, shareholders' tax rate could fall to 15% under President Donald Trump's tax proposal.

That would make owning these shares more attractive, some lawyers and tax experts say.

"There could be an impact on the value of MLPs in that a large portion of MLP earnings could be eligible for the lower tax rate," said Steve Rosenthal, senior fellow at Urban-Brookings Tax Policy Center.

The Alerian MLP Index reached all-time highs in the summer of 2014, lifted by high energy prices as many MLPs earn money by charging oil-and-gas producers to transport and store their products. The index has since turned lower. While it is up roughly 9% over the past 12 months, it remains down about 40% from its all-time high reached in August 2014.

It isn't all good tax news for MLP investors, though, some analysts say. A lower corporate-tax rate could lessen the incentive companies have to form MLPs.

"We look forward to learning the details of the president's proposal to reduce the rate for pass-throughs to 15%," the Master Limited Partnership Association said in an emailed statement.

--Corrie Driebusch

Accounting Firms And Hedge Funds

Lowering the rate on pass-through income could enhance the appeal of global law or accounting firms, hedge funds, and private-equity funds in addition to small real-estate firms, car dealers, and manufacturers. But it may also change taxpayers' behavior, some observers said, especially if the top rate on personal income is 37%.

"A large risk is that business owners will transform their wages or compensation income to avoid income, Medicare and even Social Security taxes," says Michael Graetz, a former Treasury official who now teaches at Columbia University's law school.

Laura Saunders

Berkshire Hathaway

One major company that would benefit from a lower corporate tax is Warren Buffett's Berkshire Hathaway Inc., which generates most of its revenue within the U.S.

A 15% corporate-tax rate would increase Berkshire's book value by 13%, or about $36 billion, Barclays PLC estimated in February based on the company's 2016 results.

But a change to the repatriation of foreign profits would have little effect on Berkshire, Mr. Buffett wrote in a letter to shareholders this year. Berkshire holds about $86 billion in cash, and 95% of it is in the U.S., he wrote.

When the corporate-tax rate was lowered in 1986, Mr. Buffett wrote to shareholders that the drop was likely to benefit Berkshire but not its customers, because Berkshire's businesses had strong brands and wouldn't have to cut prices.

"While this may be impolitic to state, it is impossible to deny," Mr. Buffett wrote. He also predicted that the 1986 tax cuts would "very likely bestow a fiscal problem on Washington" and would lead to higher taxes, higher inflation or both.

Nicole Friedman

(END) Dow Jones Newswires

April 26, 2017 15:55 ET (19:55 GMT)