How New Tax Cuts Will Affect Investments in 2018
By Lynn Loden & Ryan Riddle
Newly passed tax legislation (the Tax Cuts and Jobs Act of 2017 (TCJA)) has many people wondering how the new laws will affect investments in 2018. According to a recent U.S. News article, “the issue of the tax cut's fallout on Wall Street has pundits, shareholders and those waiting to make their first play wondering what's next. And while the anticipation is punch bowls for everyone, the new law raises three crucial questions: which sectors benefit most, what investors take home and how companies choose to utilize their financial windfalls.”
Positive outlook for energy and other capital intensive industries
We are already seeing cost of capital shifts due to the higher cost of debt as a result of the reduced tax benefit of interest expense deductibility, both in the rate effect and possibly in timing of the savings due to new limitations. Thus, it seems that higher leveraged entities would be under additional stress. We will see less emphasis on financial and structural engineering of cross-border investments by U.S. investors. Energy and other capital intensive industries fare well in early years due to enhanced capital expenditure cost recovery. Individual and private business owners fared well for similar reasons, and possibly better with rate reductions and phase-outs being targeted above the $150,000-$300,000 level.
Benefits for U.S. investors
For public equity holders, once their investments’ share prices have settled from the effect to the financial statements from recording the change in law, ideally, earnings will be higher, cash tax outflows will be a bit lower at first, and offshore cash representing non-U.S. earnings will be more easily repatriated. These are positive cash flows for U.S. investments, enhancing each entity’s cash position, which, in turn allows for better resources for investment in people and capital, and enhanced returns to investors. All other things being equal, the TCJA should enhance most domestic corporate valuations.
How will businesses react?
There will be a mix of uses of incremental funds as companies will be under pressure from shareholders, labor representatives, and other activists. Due to differences in income tax law and GAAP reporting of income taxes, the cash savings often does not match the financial statement treatment of income tax expense decreases, so benefits suggested in the financial statements may not actually result in tax returns for these years.
Ignoring any technical correction legislation as being just that, our sense is that overall geo-political and economic events will have a greater influence on the intended effects of TCJA. This notion is also applicable at the state or local level, as states or locales could enact legislation offsetting intended federal effects in their particular jurisdictions. Other government actions could include other countries’ reactions through changes in policy affecting cross-border commerce.
Looking back at past tax cuts as compared to the current “reform”
In addition to raising revenue (which is the stated function of revenue laws in the first place), tax policy clearly serves as a social and economic tool, as well. Significant rate cuts in 1981 for individuals and 1986 for corporations had profound effects on the economy at the time. In addition, tax law changes in the late 1980s and early 1990s played a major role in deterring hostile takeovers by lowering the incentive to issue high yield bonds that led to overpriced equities. However, we are also concerned about the lasting merits of selectively favoring certain types of earnings streams over others. For example, why is engineering and architecture favored over medicine? Is it because of the desire to have graduated income tax rates and apply a tax burden more heavily to higher income earners than others? If one is really interested in simplicity and some definition of “fairness,” selectively taxing certain earnings streams at a higher rate than others is a slippery slope, which tends to lead to mistrust in the system and complex financial mischief. As far as the deficit as a whole is concerned, there are multiple spending elements contributing to this problem that should be addressed separately from how the revenue portion of that exercise is shared.