Capital Advisors Group

Tax Reform

Central Bank Tightening, Tax Reform and Event Risk

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Abstract

At the start of each year, we typically name three broad market trends or events that could potentially have the greatest impact on the short-term debt market. For 2018, we think central bank tightening, tax reform and event risk will have the most impact on short-term debt markets. We are generally sanguine about the interest rate and credit spread outlook. What is less clear is how investors will manage a market reversal. We think the demand for institutional cash portfolios to “self-insure” against liquidity events has increased. Treasury professionals should focus on risk diversification and liquidity stratification.

Introduction

2017 turned out to be an unexpectedly blissful year by some standards. A political novice occupying the White House did not lead to the financial market volatility many had predicted, in spite of his unconventional communication style. Britain will leave the European Union, but no other country followed suit. The debt ceiling came and went… and came again, but Treasury issuances were well received. Headline news was dotted with reports of partisan politics, slowing growth in China, terrorism, asset bubbles and rising corporate leverage. Nevertheless, risk assets, interest rates and market liquidity all seem to have held up well.
In 2018, we expect the cumulative effect of monetary policy normalization from the Federal Reserve and other central banks to guide the yield curve higher. Market responses to the tax reform legislation passed in December will also shape the cash investment landscape. As in 2017, we think unknown event risk occupies a very important corner of an increasingly uncertain world.

1. Market Implications from the New Tax Legislation

The hotly contested, highly partisan Tax Cuts and Jobs Act is finally here. The estimated $1.5 trillion tax package that permanently lowers corporate income tax while providing temporary relief to individual taxpayers will touch many corners of the economy and financial markets beyond 2018. In the context of institutional liquidity management and short-term debt markets, we have the following initial reflections.
Moderate impact on Near-term Growth and Policy Rates: Despite Republican leadership’s high hopes and promises of the bill’s jolt to economic growth, economists seem to agree that the uplift will be modest. While bringing corporate profits home and giving households more cash to spend are expected to stimulate the economy, previous tax cuts between the 1960s and 2000s produced mixed long-term results. A December Wall Street Journal survey of economists showed that most forecasters thought growth pickup over the next two years from the tax bill would be moderate1. In her last press conference as Fed Chair, Janet Yellen said the legislation would provide “a modest lift” to the economy and that it would not lead to an acceleration of the Fed’s pace of rate hikes in 20182.
Higher Deficits and Treasury Issuance: The Joint Committee on Taxation (JCT) estimates that the tax law will increase the deficit by $1.5 trillion over 10 years, most of which is front-loaded, with a projected increase of $135.7 billion in 2018. Larger deficits mean correspondingly higher Treasury security issuance. Based on recent Treasury auctions and comments from government officials, nearly half of the new debt supply is expected in Treasury bills. This means that, even without the Fed ratcheting up interest rate hikes, short-term Treasury yields will be under pressure to rise more for the market to absorb higher supply.
Deemed Repatriation Changes Funding and Investment Behaviors: The closely-watched repatriation tax law will subject foreign profits accumulated from 1986 to 2017 to a one-time tax of 15.5% for cash and liquid assets and 8.0% for illiquid assets, higher than the initial Senate plan of 10% and 5%, respectively. Companies can either make payments immediately or defer them over a multi-year period. On the tax front, the estimated $2.6 trillion total offshore profits1 may translate into tax bills of $208-390 billion. How companies pay these bills will influence their liquidity management and financing decisions, and by extension, debt supply and demand dynamics across global markets. While the full impact of cash reshuffling on a grand scale will take years to materialize, we have already observed some cash investors putting their investment decisions on hold pending strategic review.
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1David Harrison, Economists see three Fed rate rises next year, lower unemployment, The Wall Street Journal, Economy Section, December 12, 2017. https://www.wsj.com/articles/economists-see-three-fed-rate-rises-next-year-lower-unemployment-1513106667
2Binyamin Appelbaum, Fed predicts modest economic growth from tax cut, the New York Times, December 13, 20017. https://www.nytimes.com/2017/12/13/business/economy/fed-interest-rates.html?mtrref=www.google.com
3Many press reports quote the $2.6 trillion figure based on a March 2017 report by Institute on Taxation and Economic Policy that combed through annual report filings of Fortune 500 corporations. https://itep.org/fortune-500-companies-hold-a-record-26-trillion-offshore/

The Trump Tax Plan and Its Implications for Cash Portfolios

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Abstract

The Republican bill represents a starting point for tax and budget negotiations. While details are lacking, the current plan offers some interesting angles for market participants to think about their liquidity investment strategies. We highlighted parts of the bill relevant to corporate cash investors and their potential impact on issuers and investors in the short-term debt market. We advise our readers to be patient, stay liquid and think strategically during this waiting period.

Introduction

After weeks of negotiations behind closed doors, Republican leaders unveiled a nine-page document on reforming the tax code on September 27, 2017. Politicians and market pundits quickly jumped into action, looking at every angle to determine potential winners and losers from the proposal. The long-on-promises and short-on-details nature of the so-called “Trump tax plan” left out many details, rendering many of the projections little more than conjectures and educated guesses.
Since the tax framework touches many important subjects that impact the corporate treasury management community, we want to keep the dialog going by addressing the plan’s potential impact on market liquidity and treasury investment strategies. Although the plan represents an early blueprint of the finished legislation, understanding the key issues at stake may assist our readers with their internal discussions and perhaps advanced planning.
For the purpose of this commentary, we focus on the aspects of the tax plan we deem to have direct impact on treasury portfolio strategies.

Summary of the Tax Plan

Below is a high level summary of the “unified framework for fixing our broken tax code” released on September 27, 2017.
1) Personal Taxes

  • The seven tax brackets are consolidated into three (12%, 25% and 35%). Income levels associated with each bracket are unknown. It leaves the possibility open for an additional top tax rate for high earners.
  • The framework roughly doubles the standard deduction while removing allowance for personal exemptions.
  • It eliminates most itemized deductions, but retains deductions for home mortgage interest and charitable contributions. Tax benefits to encourage work, higher education and retirement security will also remain.
  • It calls for increased child tax credit and higher income levels at which the credit begins to phase out.
  • It repeals the alternative minimum tax (AMT) and the estate tax.
  • It envisions the use of a “more accurate measure of inflation” to index the tax brackets and other tax parameters.

2) Corporate Taxes

  • It reduces the corporate tax rate from 35% to 25% and eliminates corporate AMT. It limits the maximum tax rate for pass-through entities to 25%.
  • It allows businesses to immediately write off the cost of capital investments for at last five years.
  • It partially limits the deduction for net interest expenses by corporations. It repeals or restricts most. exclusions and deductions. It explicitly preserves tax incentives towards research and development (R&D) and low-income housing.
  • It will subject foreign profits of US corporations to a lower tax rate on a global basis than domestic earnings.
  • Accumulated offshore profits will be considered already repatriated. No specific repatriation tax rates were supplied, but illiquid assets will be subject to a lower tax rate than cash or cash equivalents. Payment of the liability will be spread over several years.

Items of Interest to Institutional Cash Accounts

The lack of details makes it difficult to gauge with accuracy how the new law will impact the corporate cash investor. With this caveat, we provide a few items of relevance.
A) Lower corporate tax rate to 20%
A lower corporate tax rate would immediately boost profitability and business activities, leading to more hiring and capital spending, higher dividends and share buybacks, higher equity valuation and the wealth effect. The list of potential positive effects of corporate tax cuts is understandably long. The biggest beneficiaries would be firms with higher effective tax rates, including banks.
Banks will benefit from lower corporate tax rates in two ways – from direct tax savings and from robust client activities such as higher business loan demand and higher investment banking activities. As an example, executives of Citigroup and Morgan Stanley estimated that the reduction of the corporate tax rate to 25% (the Trump plan calls for 20%) would lift the banks’ earnings by 5% and 15%, respectively1.
Issuers with high effective tax rates tend to access the short-duration debt market more frequently due to the tax benefits. We think that, over the long-term, investors will benefit from better credit ratings of corporate borrowers in a low tax rate regime when economic growth picks up and firms’ fundamental credit strength improves. Borrowers with tarnished credit profiles that languished in a sluggish economy may become creditworthy enough to return to the short-duration debt market.
B) Full depreciation of capital spending
The immediate full expensing of capital investments for five years encourages companies to make more capital purchases more quickly. Understandably, this provision will benefit firms in industries that are more capital intensive and with high effective tax rates, including manufacturing, materials and resources and telecommunications. Increased capital spending is no doubt stimulative to the economy, and one would expect higher debt issuances from these industries to fund capital expenditures.
C) Reduced deductibility of corporate net interest expenses
Offsetting the immediate tax write-offs of capital expenditures, the elimination or reduction of tax deductions of net interest expenses may hurt companies relying on borrowed funds for growth. The current tax system of giving preferential treatment to interest over dividend receives frequent criticism for encouraging firms to take on more risk by funding themselves with debt instead of equity shares. The new proposal would likely increase funding costs for firms with below invest grade credit ratings, issuers of high yield bonds, and mergers and acquisitions deals funded with leveraged loans.
Banks as a special class of borrowers may be exempt from this provision. The tax plan said negotiators “will consider the appropriate treatment of interest paid by non-corporate taxpayers.” Banks could argue that in the course of conducting normal banking businesses, their interest expenses are akin to costs of goods sold for non-financial firms.
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Our research is for personal, non-commercial use only. You may not copy, distribute or modify content contained on this Website without prior written authorization from Capital Advisors Group. By viewing this Website and/or downloading its content, you agree to the Terms of Use.

1Telis Demos, Liz Hoffman, Justin Baer and Rachel Loise Ensign, What awaits Wall Street in Trump tax plan, the Wall Street Journal, Markets section. September 29, 2017. https://www.wsj.com/articles/what-awaits-wall-street-in-trump-tax-plan-1506596402

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