In a number of places around the world, it’s an exciting time to be a taxpayer — or tax attorney. That’s because a variety of countries have brought or are bringing tax cuts to fruition.
At the end of 2017, the US saw the passage of a tax reform bill with many elements to it, ranging from household tax cuts to corporate tax cuts. In France, tax cuts, including a business tax cut, were implemented. The Netherlands and Belgium both enacted tax cuts in 2017. In December, Japan enacted new corporate tax cuts, including ones tied to incentives. And other countries are pondering corporate tax cuts in order to remain competitive with those countries that have already lowered taxes on their businesses.
Not all tax cuts have the same impact
There can be an assumption on the part of investors that all tax cuts are a positive for the economy and markets. For example, the US Treasury Department has forecasted that the Trump administration’s entire tax reform package will be very economically impactful, increasing gross domestic product growth by 0.7% on average per year over the next decade. However, that tax package is comprised of a variety of different tax cuts. And while tax cuts have historically stimulated their respective economies, not all tax cuts are created equal. The Congressional Budget Office has analyzed the impact of various tax cuts in the US, indicating that tax cuts for lower- and middle-income individuals historically have produced a greater multiplier effect than tax cuts for higher-income individuals and corporations. But that, of course, is a gross generalization. My colleague Kevin Holt, Chief Investment Officer of Invesco US Value Equities, wrote in his 2018 outlook that he believes the repatriation tax cut will be a one-time jolt, not an ongoing benefit. However, he believes the real economic benefit will come from the drop in the corporate tax rate — from 35% to 21%. Kevin also noted that this tax cut could result in wage inflation, which in turn could place upward pressure on the 10-year Treasury yield — a potentially positive development for value stocks and active management.
I agree with Kevin that US corporate tax cuts could have a significantly positive impact on the economy, which in turn is likely to favor more cyclical stocks. All else being equal, earnings will improve for most companies whose effective tax rates are lowered, which is likely to place upward pressure on stock prices. In addition, corporate tax cuts incentivize capital spending, which should provide a return on investment in years to come.
The potential consequences of tax reform
It’s important to recognize that taxes are a way for governments to not only collect revenue, but to incentivize certain behaviors. As I mentioned, the new US tax legislation encourages business investment by offering tax benefits for capex spending. Japan’s recent corporate tax reform legislation does something very similar: It offers lower tax rates to companies that raise employee wages and/or spend on capex — two behaviors that the Japanese government clearly wants to encourage. Historically, US home ownership has been rewarded with generous tax deductions. And since the 1990s, saving for college has been incentivized through the tax deferrals offered by 529 college savings plans in the US. (The new US tax law expanded that incentive to include certain federal tax benefits for families saving for K-12 private school as well.)
However, new tax laws can alter or eradicate incentives as well. The 2017 Tax Cuts and Jobs Act has changed some incentives that could have a significant impact on the US economy. For example, the deduction that households can take for mortgage interest was capped going forward, as was the deduction that households can take on property taxes. This of course reduces the tax advantages of homeownership in general. In particular, it disadvantages states with high taxes and states with high home prices, which are for the most part one and the same. As my colleagues at Invesco Real Estate explained:
“Most economists agree that the passage of tax reform legislation should result in a modest uplift to near-term US economic growth, driven by a reduction in the corporate tax rate, a lowering of personal tax rates for most Americans, and other stimulative measures. However, upcoming changes regarding the deductibility of state and local income taxes and mortgage interest may have far-reaching implications with a direct impact on commercial real estate fundamentals. These changes will likely have a negative impact on higher-tax jurisdictions, such as New York, New Jersey and California. More specifically, the changes may result in a lower propensity for home ownership and may accelerate the ongoing demographic shift to lower-tax states. Additionally, lower disposable income in higher-tax markets might negatively impact consumer spending, thereby impacting the retail, storage, multifamily and seniors housing sectors. While lower-tax states may benefit from these trends, the generally low barrier for new real estate orientation of these markets may serve as a modest offset to increased demand for real estate.”
In the US, interest on corporate debt, which had heretofore been fully deductible, is now capped at 30% as a result of the 2017 legislation. This will likely decrease the amount of debt that corporations rely on for financing, since there are not as many tax advantages to issuing debt. This is particularly so given that the corporate tax rate has been reduced; this also lowers the value of the deduction. In addition, my colleague Matt Brill of Invesco Fixed Income wrote in a recent blog that the new legislation, which creates a repatriation tax of 15.5% on liquid assets and 8% on illiquid assets, should encourage companies to bring back their own overseas cash rather than borrow funds through bond issuance in order to fund dividends and stock buybacks. Matt estimates that the net result would be additional corporate deleveraging and a significant drop in the supply of bonds going forward as companies issue less debt. Overall, he believes US tax reform is “overwhelmingly positive” for the US investment grade bond market.
Will the benefits of tax cuts outweigh the concerns?
In short, tax cuts in the US and around the world have the potential to be a source of positive stimulus for their respective economies — and have an impact on financial markets. However, we must hope that the benefits of the tax cuts offset the disadvantages. For example, tax cuts typically result in lower tax revenues and higher sovereign debt levels, as they often don’t pay for themselves because their respective multiplier effects are not high enough.
In addition, there is legitimate concern that implementing tax cuts at a time when the global economy is accelerating could cause the economy to overheat. For example, the US Federal Open Market Committee contemplated the impact of tax legislation on the economy in December, as was indicated in the group’s meeting minutes. Concerns about the economy overheating could cause the US Federal Reserve (Fed) and other central banks to pre-emptively tighten monetary policy, or tighten too quickly. Last week, Federal Reserve Bank of New York President William Dudley warned about this possibility, suggesting that the Fed may have to “press harder on the brakes” in the next several years if the economy accelerates, which increases the possibility of a hard landing for the economy. Even more concerning is that these tax cuts are occurring in the midst of a global economic growth cycle. If tax cuts — an arguably potent form of fiscal stimulus — are occurring now, with a global growth acceleration in the works, then we have to worry about what dry powder we will have available when the economy next goes into recession, whenever that occurs.
In summary, there are many implications of tax reform around the world. I hope to return to this topic in future commentaries in order to more fully explore implications in different countries.