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SkyView Investment Advisors: 2018 Commentary — In Four Parts Part 2

Date Posted: December 2, 2017

Tax Reform—Will It Pass?
The chances tax reform clears Congress remains somewhat uncertain as of this writing. The odds increased significantly yesterday when it cleared the Senate budget committee. The bill now moves to the Senate floor for a final vote. If the Senate ultimately passes the tax reform bill, it still must go through the House-Senate conference committee to iron out important differences between both measures. For purposes of this commentary, we assumed passage of tax reform before yearend.

Timing of Corporate Earnings Impact
Most important to investors, tax reform will produce increased corporate earnings. The House bill immediately slices the current 35% corporate tax rate to 20% in 2018. The Senate bill postpones that reduction to 2019. Based on estimates from observers, the corporate tax reduction in the House bill could add 5-10% to earnings per share in 2018. Corporations with principally domestic earnings will show the greatest earnings benefit. In particular, mid and small cap and telecom stocks fit that description.

Tax Reform Not Just Tax Rate Reductions
In our past commentaries, we suggested Congress would wind up passing just tax rate reductions and not actual tax reform measures. In fact, this potential legislation contains important tax reforms. In our opinion, moving the United States from a global to a territorial taxation system will prove to be among the most important tax reform measures in the bill. That change, alone, will put U.S. corporations in a more competitive position; eliminate the attractiveness of inversion; and reduce their exposure to unwanted international takeover bids.

Without getting into the details, the tax bill will also likely result in the repatriation of over $2.5 trillion of cash positions held overseas by U.S. corporations. That cash pile represents nearly 14 percent of U.S. GDP. Repatriated cash will find its way to increasing capital investments and dividends and most importantly increasing acquisition activity. Corporations could also use that cash to repurchase stocks. However, we would question whether that makes good financial sense for those stocks currently selling at record valuations—particularly tech stocks.

Tax Reform Repositions the U.S. Competitively
Overall, tax reform will effect corporations more so than individuals. Proposed tax reforms will reduce corporate tax
expenses by an estimated $0.6- $1.1 trillion. This compares to a tax reduction of $200-$900 billion for individuals. The corporate tax reductions could cause rethinking of long-term business strategies for U.S. corporations. Reduced U.S. corporate tax rates could also encourage U.S. global and international corporations to locate more of their new facilities in the United States rather than overseas. It becomes somewhat of a chicken and egg question. The ultimate attractiveness of investing in this country will depend on U.S. economic growth relative to the rest of the world. If tax reform increases foreign direct investments in this country, then this country’s relative economic position will improve.

Tax Reform Should Produce Increased Capital Spending
For the first five years of the new tax law, businesses will be able to immediately write-off their capital investments. Part I of our commentary showed increased capital spending already occurring with the maturing business cycle. The new capital spending incentive should spur and therefore lengthen this capital investment cycle. The interesting question will be whether such increased capital investments will ultimately move U.S. productivity off its current low base. In any case, rising capital spending certainly could produce higher economic growth. It will also add to the earnings growth of capital equipment suppliers as well as engineering, construction, and production equipment companies.

Partial Limit on Interest Expense Deductions
One change that could negatively affect corporations, as well as private investment partnerships, will be the partial limit on interest expense deductions. The Senate and House bills differ importantly of key details of that limitation. The House bill caps the deduction at 30% of EBITDA. In comparison, a more restrictive Senate bill limits interest expense deductions to 30% of only earnings before interest and taxes. Therefore, the Senate version puts a greater interest expense burden on capital intense companies. The Senate provision, if in the final bill, could negatively affect private-equity buyout activity.

Tax Reform—Individuals and the Economic Impact
Many, but certainly not all, moderate income Americans will benefit from a combination of lower individual tax rates and doubling the standard deduction. Many will see increased take home pay in their January pay checks. These individual tax changes will disappear in 2025. At that time, desiring to be reelected, Congress will likely extend the tax changes for individuals. Moderate income Americans tend to spend–not save–most of their additional income from wage increases or tax reductions. Therefore, companies that focus on this market should benefit as these consumers receive bigger pay checks. At the same time, State and Local Tax (SALT) and other changes in the tax bill may create an increased tax burden for upper income W-2 tax payers. The result, sales of luxury housing may suffer.