From Buffett to Small-Cap Stocks, the Impact of Trump's Tax Plan -- 2nd Update
President Donald Trump on Wednesday is planning to unveil a proposal to cut corporate taxes and reduce the top tax rate on so-called pass-through businesses, including many owner-operated companies, to 15% from 39.6%, White House officials familiar with the planning have said.
Here's what the change would mean for Wall Street:
S&P 500 EARNINGS
Donald Trump's tax proposal is expected to cut the corporate rate to 15%, potentially providing a big lift to corporate earnings for publicly traded companies.
Every one-percent 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 Tuesday 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.
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 companies make most of their profits on domestic sales.
Investors were counting on a Trump 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.
Dollar bulls are cautiously optimistic about the Trump tax plan. Even though an early 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 their overseas earnings, a provision that wasn't mentioned in an early outline of the plan. 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.
Banks could get a double benefit from a tax cut. It will fatten their own bottom lines, but also those of their customers. If customers then invest more and spur economic growth, that could fuel more lending, further bolstering banks' profits.
One fly in the tax-cut 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.
The White House's plan for a so-called 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 reforms, 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 grow 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 where 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.
ACCOUNTING FIRMS & HEDGE FUNDS
Lowering the rate on pass-through income could enhance the appeal of these businesses. But it may also change taxpayers' behavior, experts 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 under George H.W. Bush who now teaches at Columbia University's law school.
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 estimated in February based on the company's 2016 results. A 20% corporate tax rate would increase Berkshire's book value by 10%, or $27 billion, the bank's analysts said.
However, a change to the repatriation of foreign profits would have little effect on Berkshire, Chairman Warren Buffett wrote in a letter to shareholders released earlier 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.
(END) Dow Jones Newswires
April 26, 2017 12:59 ET (16:59 GMT)