Economic Commentary: 2018 Tax Cuts and Jobs Act

Written by CUNA Mutual Group Annuities

Recently passed and formally enacted on January 1, 2018, the 2018 Tax Cuts and Jobs Act introduces a number of significant changes to the tax code, with about one-third directed to individuals and households, and the remaining two-thirds impacting corporations — notably a tax rate reduction from 35% to 21% and immediate 100% expensing of capital expenditures for equipment and machinery.

In this month’s Economic Commentary, Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., shares his perspectives on the potential impact of the changes, the positives and negatives that come along with the tax bill and what it all could mean for investors.

QA with Robert DeLucia

What are the key components of the new tax act?

The 2018 Tax Cuts and Jobs Act contains changes to the tax code that affect both individuals and households, but pertains mostly to business firms. The most important provisions include the following:

  • Individual tax rates are reduced for all income groups, amounting to $1 trillion in cuts over the next 10 years. For example, a family of four earning a median income of $73,000 will receive a tax cut of $2,059. Tax cuts for lower-income families mean that more than four million families will be dropped from the tax rolls.
  • The corporate tax rate is reduced to 21% from 35%. Previously the highest in the industrial world, the statutory income tax rate on U.S. corporations and small businesses — partnerships, sole proprietorships and limited liability corporations — is now slightly below the world average.
  • Businesses are allowed immediate 100% expensing of capital expenditures for equipment and machinery, although this provision will sunset in 2022. The recovery period for nonresidential structures such as factories and office buildings is shortened from 39 to 25 years.
  • Multinational corporations can now repatriate the estimated $2.5 trillion of unremitted foreign earnings worldwide at a reduced rate of 15.5%.
  • The new law shifts the tax system from “worldwide” to “territorial” for companies doing business outside the U.S., effectively eliminating the double-taxation of foreign profits.

How should investors assess the significance of the tax act for the economy?

Most mainstream economists believe that the new tax law will have only a modest impact on the real economy and that the effects will be short-lived, principally because the tax cuts for individuals — $1 trillion over 10 years — are small and business tax cuts are of minor relevance.

I happen to disagree with part of this superficial assessment. While the analysis regarding individual taxes and the minimal enduring impact on consumer spending appears accurate, I feel it’s somewhat misguided because it’s too focused on individuals. What is missed in the debate are the implications for capital accumulation emanating from reduced taxes on business. Simply put, several key provisions in the tax bill should result in a massive increase in private capital creation over the next several years, favoring growth and prosperity.

As a general principle, free market capitalist economies derive the greatest benefits from tax cuts on capital rather than cuts on income or spending. Lower corporate taxes will also make U.S. companies more competitive within the global economy, which benefits both U.S. workers and shareholders.

How does passage of the 2018 Tax Cuts and Jobs Act alter your forecast for the next two years, both positively and negatively?

The new tax act could have a significant positive impact on the U.S. economy over the next two years, including:

  • Consumer spending in 2018 and 2019 will receive a modest and finite boost from cuts in individual tax rates, estimated at 0.3% in each year
  • Business capital investment should benefit from a lower corporate tax rate and from the immediate write-off of outlays for equipment purchases
  • Corporate after-tax profits should receive a one-time boost of approximately 4-8% in 2018
  • More aggressive expansion plans within the non-financial business sector should result in faster growth in both job creation and wage rates
  • Lower taxes on capital in the domestic economy should attract international capital flows, which was positive for growth but could exert upward pressure on the value of the U.S. dollar
  • Overall, U.S. GDP growth could average 0.8% higher than otherwise in 2018 and 0.6% in 2019 as a direct result of tax reform

There are also negatives associated with the tax bill, including:

  • A rising trend in federal budget deficits could add to government borrowing and trigger a sustained rise in long-term interest rates, encouraging the Federal Reserve to accelerate the pace of its rate-tightening cycle
  • Although the tax bill should benefit all income groups, there is very little in the new legislation to address income and wealth inequality
  • Provisions pertaining to pass-through entities are highly complex

The primary risk in the medium term, however, pertains to a potential overheating of the domestic economy. A sustained rise in inflationary expectations could trigger a more aggressive tightening in monetary policy, which in turn would exert upward pressure on government bond yields. An economy already growing at a pace in excess of its long-term potential could easily succumb to overheating pressures, which could pull forward the next recession.

Looking at the positives and negatives you outlined on the whole, what do you feel are the investment implications of the tax bill?

The boost to economic and profit growth over the next one to two years would initially be positive for common stocks and negative for bonds. However, beyond the medium term, a potential rise in inflationary pressures could trigger a faster rise in bond yield and a more aggressive tightening by the Federal Reserve in the context of an overheating economy. The end result could be a worrisome combination of slower real GDP growth and higher inflation.

This potential scenario would eventually be negative for the equity market. Higher interest rates would raise the discount rate applied to long-term financial assets, triggering a rise in bond yields, a decline in the price-to-earnings ratio (P/E) on stocks, and a rise in the cap rate on commercial real estate. Higher borrowing costs would also lead to a slowdown in aggregate spending and output. The critical variable in the outlook in inflation: The sensitivity of inflation to faster growth in aggregate spending and output in a fully employed economy will ultimately determine the future direction of financial markets.

The 2018 Tax Cuts and Jobs Act brings with it cautious optimism, which could inspire your clients to reconsider their investment strategies. You can easily include a risk control assessment in your clients’ portfolio reviews using the checklists and assessment grids found in the Guide to Conducting Risk Control Review.

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