Tax overhaul winners and losers

The Tax Cuts and Jobs Act is poised to boost a U.S. economy already running at full capacity.

A windfall from lower taxes and incentives for capex could spur more consumer and business spending and corporate deal-making. A likely convergence in tax rates could create winners and losers, rippling across sectors and companies.

A 30-year rewind is informative. In the decade following the 1986 U.S. tax reforms, companies paying a relatively high share of their income in taxes saw their effective tax rates drop. Low effective tax payers saw a small rise as reforms leveled the playing field and closed loopholes. Effective tax rates started diverging again in the late 1990s as globalization, the adoption of territorial tax systems and relatively high top U.S. tax rates encouraged tax avoidance schemes. We believe something similar may play out today. The top quartile of U.S. companies currently pay an effective tax rate of 34% or more, our analysis shows. This leaves plenty of room for relief as the top rate is slashed to 21%. Lightly taxed companies, by contrast, may see their rates go up over time.

Looking beneath the surface

The overhaul of the U.S. tax code includes supply-side reforms and injects significant near-term demand stimulus into a U.S. economy running at near-full employment. A faster-growing U.S. may accelerate global growth, and result in rising inflation, higher Treasury yields and steeper yield curves. Look for a deep dive into how the tax changes and potentially higher U.S. government spending may affect the economy and interest rates in our upcoming Global macro outlook.

The tax cuts create winners and losers in the corporate sector. The drop in the top statutory rate will broadly benefit U.S. companies with high effective tax rates. But some of the benefits for these companies appear to be priced in already, suggesting investors need to look beneath the surface to identify the longer-term winners. There is significant dispersion within industries, sub-sectors and companies. The sustainability of increased corporate profitability derived from tax cuts will also vary. Companies in highly competitive industries, for example, will likely see a temporary profit boost that is quickly competed away. Changes to companies’ spending and investment plans because of the tax law are key details to watch through the fourth-quarter earnings season. We expect U.S. global corporations to scrutinize the new tax code’s complex international rules in an effort to manage any rises in their effective tax rates.

In credit markets, we see investment grade companies benefiting from lower tax rates. Yet we see most of the impact going to shareholders rather than toward paying down debt. High yield companies benefit from lower tax rates and immediate expensing of capex. But we expect more bifurcation between higher- and lower-quality issuers, as ones with large debt loads face limits to interest expense deductibility. This reinforces our up-in-quality credit stance. Municipal bonds emerged relatively unscathed, even as advancedrefunding bonds lost their tax-exempt status. This is set to shrink issuance, a factor we see supporting valuations.

Richard Turnill – Global Chief Investment Strategist – BlackRock