I learned my most important lesson on taxation from my mother. My mother was a teacher and my father a chemical engineer. Every summer my mother taught summer school, but one summer she stopped. When I asked her why, she explained the extra income that year would push my parents into a higher tax bracket, which would mean she would keep very little of her added income. So she decided the extra work wasn't worth it.
That lesson that has stayed with me.
The incentives and disincentives inherent in any current tax system affect economic behavior. If you tax a specific economic activity, you get less of it, and if you subsidize it, you get more — it's not hard to understand. And the incentive effects from a change in the tax system are far more important than the dollar value of tax cuts or tax increases. The broad strokes of last year's Tax Reform and Jobs Act are unambiguously positive for U.S. economic growth. It is the most significant piece of tax legislation since the Reagan administration.
Table 1 highlights some of the simple math involved in the tax law changes in regards to a shareholder's retention of dividend payments after applying the combined tax rates on corporate and business pass-through income and individual income tax rates.
Under the prior tax law's statutory corporate tax rate of 35% and the marginal tax of 23.6% on qualified corporate dividends, an investor retained approximately 49% of a corporation's pretax income distributed in the form of dividends. The fact that this amount is less than 65% (corporate after-tax retention rate) reflects the impact of the double-taxation of dividends. Because pass-through businesses are taxed only once, however, the after-tax retention rate is higher, at more than 60%, even at the top marginal personal tax rate of 39.6%.
Due to the reductions in the corporate tax rate to 21%, in the top marginal personal bracket to 37%, and with the 20% exclusion of profits from taxation for many pass-through businesses (S corporations and limited liability companies), the after-tax dividend retention rate rises by 17% and 22%! No wonder investors, who seek after-tax returns not pretax returns, bid up stock prices as the prospects for tax reform gained momentum. The financial rewards to working, saving and investing have been boosted.
The market pushed up future growth expectations and attached a higher price/earnings multiple to the higher earnings. In a sense, the rising tide already has lifted all economic boats. How far can it go?
How high will the economic tide be?
The broader effects on the economic and financial markets should be felt soon because the changes passed in December are not phased in. The Trump administration considered phasing in the corporate tax cut but in the end, wisely made the changes apply to 2018.
While it still takes time for businesses to rev up their activities, separate from other impacts (such as bad trade policies), one could reasonably expect real GDP growth in the U.S. to accelerate to 3% or more from the 2% level that persisted from the end of the Great Recession. Much of that growth will come from more rapid business formation (also in part due to the reduction in the burden of regulations), continued hiring and accelerated fixed investment with foreign profit repatriation and 100% tax expensing. Even if inflation rises modestly, our research suggests the overall U.S. economy might see nominal GDP growth accelerate by 1 to 1.5 percentage points from the 2% real GDP, 2% inflation levels of the prior eight years. This is a rough aggregate measure of the rise in the growth rate of corporate domestic revenues that, even with rising discount rates, could still see p/e ratios rise with faster S&P 500 earnings growth over the next three to five years.
S&P 500 earnings could see a one-time upward shift due to the reduction in statutory and effective tax rates on domestic earnings. While the lightening of the burden of taxation raises after-tax margins, the potential increase will be somewhat reduced as companies "invest" some of the tax savings to stay competitive. In our view, S&P 500 normal earning power should be boosted by 7% to 10% along with another 7% to 10% in normalized p/e ratios due to the tax rate changes.
With the near 22% rise in the S&P 500 in 2017, has all of that "good news" already been discounted? Probably not. The prospects for tax reform didn't gain traction until the end of last summer. It would, however, be reasonable to believe that much of the S&P's gains in the fourth quarter and in January (the combined amount of which equated to nearly a 13% rate of return) were a result of the new optimism about profits and valuation. So, perhaps half of the upward adjustment has occurred.
Naturally there will be relative winners and losers from the tax changes, and the further caveat is that the negative impact of trade wars could sink those steel boats even while the tide would otherwise be rising. By our estimates, midteens returns on stocks could be achieved over the next five years if trade disputes are resolved, whereas mid-single-digit returns or less would be more likely if the U.S. stirs up a serious trade battle that would destroy many incentives to invest in the U.S.
Andrew W. Bischel is CEO and chief investment officer of SKBA Capital Management LLC, San Francisco. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.