What Corporate Tax Rate Cuts Could Portend …..If Anything?

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Corporate Tax RateDespite the Russians in the woodpile, there is a chance that a corporate tax cut could take place within the next year or two. While the question is a bit rhetorical, what might be the potential effects?

According to Vinay Pande, CIO for UBS, the markets aren’t pricing in gains from a promised corporate tax cut by President Trump. Analysts are apparently skeptical that the Trump administration will be able to deliver on many of the important campaign promises until the Russia probe is completed. However, analysts may be overly skeptical believing that Congress can get its act together. So, will corporate America and investors get caught flat-footed if a corporate tax program does pass in the near-term?

The U.S. has one of the highest statutory corporate tax rates in the world, yet we find that smart companies are increasingly using sophisticated tax management schemes to reduce their effective rate (defined as income statement tax expense divided by pre-tax income). A tally of the largest 500 companies with three consecutive years of positive taxable income (excluding REITS and MLPs) finds that indeed the average effective tax rate (including federal and state tax payments) has declined from above 35% in 2002 to 29% currently.[1]

The graphic below demonstrates the estimated potential effects on various industries under 15, 20 and 25% tax brackets along with an average state tax of 4%.

Tax SAvings Under Different Federal Tax Rate Scenarios

 

Of course, the looming question is: How much of the potential tax savings would be repatriated back to the USA? On the one hand, if companies get to pay lower taxes, they have more money to invest in new innovations and perhaps more hires not only at home but also offshore. Lower taxes could entice new companies to settle in the U.S., and could convince companies that have offshored some of their business to bring those parts back. But on the other hand, cutting taxes doesn’t necessarily mean that companies will create jobs—they could just hold onto the extra cash or distribute the profits to shareholders and those at the top.

Indeed, as with most things with financial accounting, just reducing tax liability may not have a direct effect on earnings and stock prices. According to a study done by the Leuthold Group,  the earnings impact of a deferred tax asset/liability write-down is the incentive for companies to accelerate, or defer, income recognition in response to a coming lower tax-rate regime. Companies with a large amount of deferred tax assets have a strong incentive to accelerate income recognition so these assets can be utilized under the higher tax rate environment. For other companies, especially those with net deferred tax liabilities, the incentive is on the opposite end. Management would be inclined to defer income to the lower-rate years. This could add some real variations in reported income and related stock prices. On an intuitive level, cutting taxes should be a positive thing for the US economy but it is not guaranteed. As typical of these financial times, what was normal is no longer.

[1] https://www.advisorperspectives.com/commentaries/2017/02/03/impact-of-lower-corporate-tax-rate

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