Global Macro Strategy

A weekly analysis of timely economic strategy issues from Wells Fargo Investment Institute.

February 22, 2017

Ken Johnson, CFA, Investment Strategy Analyst
Paul Christopher, CFA, Head Global Market Strategist

Tax Reform

  • In the coming weeks, we expect new details from Congress on a plan to cut corporate tax rates.
  • Lower corporate tax rates should have notable long-term benefits for the U.S. economy and corporate earnings, although the implications for 2017 may be more mixed.

What it may mean for investors

  • We maintain our forecasts for moderate U.S. economic expansion, inflation, and earnings growth in 2017, and we advise investors to watch carefully for corporate tax plan details that could have a more significant economic and market impact this year.

In the coming weeks, we expect several new initiatives to be announced that could impact the domestic economy, corporate profits, and the capital markets. One issue that is likely to gain traction is corporate tax reform. In this week’s report, we analyze potential corporate tax-reform policies and how they may influence the U.S. economy.

The top U.S. statutory corporate-tax rate is currently 35 percent, but available deductions reduce the average effective tax rate for companies in the S&P 500 Index to roughly 26 percent. President Trump and the Republican-led Congress both have proposed the following policies that lower the statutory tax rate, remove interest deductions, and allow full expensing of expenditures on plant and equipment (known as capital expenditures or “capex”).

Table 1. Summary of Main Corporate Tax Reform Provisions Being Discussed in CongressTable 1. Summary of Main Corporate Tax Reform Provisions Being Discussed in CongressSource: Wells Fargo Investment Institute, 2/17/17.

Mixed Economic and Market Impact in 2017

Our research suggests a mixed short-term market and economic impact. Lower tax rates should support stronger corporate spending, hiring, and earnings, but a large cut in the statutory tax rate may deliver a more limited economic and market impact. The effective tax rate might not decline by as much as the statutory rate, because the elimination of interest deductibility would leave more revenue exposed to tax.

There also could be an immediate slowdown in merger and acquisition activity, with potentially negative equity-market implications. Companies today can deduct interest expenses, and low long-term interest rates encourage merger and acquisition activity financed by debt at low interest rates. Mergers and acquisitions hit record levels over the past few years as companies capitalized upon cheap debt financing. Removing the interest-expense deduction could undercut this trend and may lead to an increase in equity issuance, which could dilute corporate profits and potentially weigh on equity prices.

Potential for More Positive Market and Economic Effects in the Long Term

The benefit for the domestic economy and corporate earnings could be more substantial in the years to come. In particular, the deductibility of capex spending encourages companies to invest more to upgrade and expand their production facilities. Both the president and Congress support this change, and we see a higher probability of it becoming a reality than some other tax-related initiatives. Depressed capex spending has weighed on economic growth in the past several years. Still, the removal of the interest deduction, coupled with full capex expensing, should allow companies to emphasize internal capital investing. As a result, investors could see a jump in nonresidential fixed investment in the coming years.

Chart 1. Growth in Corporate Capital Expenditures (Year-Over-Year Percentage Change)Chart 1. Growth in Corporate Capital Expenditures (Year-Over-Year Percentage Change)Source: Bloomberg, Wells Fargo Investment Institute, 2/17/17. Capex spending is represented by non-residential fixed investment. Quarterly data, March 2000 – December 2016.

As efficiency expands across the U.S. economy, more economic output should be generated for the same inputs of labor and raw materials. As workers and shareholders split the additional productivity, wages and earnings should rise. Meanwhile, the added productivity growth should allow firms to produce more without aggravating inflation pressures. The combination of earnings growth and limited inflation should be positive for domestic equity markets over time.

The Political Environment Matters

The combination of changes presented in Table 1 should reduce federal revenue. The Congressional Budget Office reported that the U.S. government received approximately $300 billion in corporate tax revenue in 2016. If lawmakers pass the proposed changes purely as tax cuts (with few, if any, offsets to raise revenue), Congress will reduce corporate tax revenue and widen the federal deficit. Also, cutting taxes without replacing the revenue would require a 60-vote majority in the U.S. Senate, and such broad support appears to be lacking in Congress at this time. Alternatively, tax reform that would recoup the lost corporate revenue appears to have bipartisan support and would need only a simple 51-vote majority to pass. The main option for replacing the revenue is the so-called border-adjustment tax, which would tax imports and subsidize exports. Yet, this proposal is highly controversial and has evenly divided the Senate. Consequently, corporate-tax changes have a difficult path through Congress. The president has promised more details in a planned February 28 speech before a joint session of Congress.

Economic Implications

Historically, most of the major U.S. tax-reform bills have supported long-run economic growth and corporate profitability. Today’s proposals are unique, and their impact will depend on how (and whether) Congress determines to recoup lost corporate-tax revenue. We believe that investors will not wait for a formal law or implementation but will anticipate the economic and market effects as more details emerge in the coming weeks. Thus, for now, we maintain our 2017 forecasts for moderate U.S. economic expansion, inflation, and earnings growth, but it will be important to carefully watch the deliberations in Washington during the coming weeks.

Risk Factors

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers.

Definitions

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment.

An index is not managed and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.

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