How should investors be thinking about tax reform?Contributor David Lebovitz
Recent headlines have been dominated by the issue of tax reform, as the Senate Budget Committee successfully advanced its proposed plan to the Senate floor last week. While the final tax bill will undoubtedly look quite different from what has been proposed in both the House and the Senate, the key question for investors is which companies stand to benefit the most, or the least, from the proposed reforms.
The headline corporate tax rate in the United States currently stands at 35%, but the effective corporate tax rate of S&P 500 companies – in other words, the tax rate that they actually pay when all is said and done – is lower, at around 25.6%. Furthermore, as shown in the chart below, there is significant dispersion across S&P 500 sectors when it comes to the effective tax rates. On the one hand, REITs do not pay taxes at the corporate level, and the dividends that investors receive are taxed at their individual tax rate. Meanwhile, technology companies have set up operations around the world in an effort to pay the lowest tax rates possible, while telecommunications companies have the highest effective tax rate of all the sectors in the S&P 500. When it comes to taxes, not all sectors are created equal.
Claims have been made that corporate tax cuts could boost wages, or that the full deductibility of capital expenditures could lead to an uptick in investment spending and a subsequent improvement in productivity. Will this happen? Only time will tell. In the interim, correlations are at multi-year lows, as stocks trade on fundamentals, rather than in broad risk-on or risk-off moves. Given this backdrop, an active approach focused on those companies that stand to benefit the most from a lower corporate tax rate seems to be a prudent investment strategy.
When it comes to tax rates, not all sectors are created equal
S&P 500 effective tax rate by sector, 2016
Sources: Standard & Poor’s, J.P. Morgan Asset Management.