The success of the most far-reaching U.S. tax overhaul in decades will depend on whether American companies invest their tax windfall on expanding hiring and production capacity or save it for dividends and share buybacks that, while they increase shareholder value, do little for economic growth, according to three PGIM thought leaders.
The 2017 Tax Cuts and Jobs Act—most notable for its significant 14 percentage point cut on corporate taxes to jumpstart the Trump administration’s job creation efforts—was signed into law by the president three days before Christmas. Expectations are equally significant for the stimulus the legislation will have on the U.S. stock market and economy in the new year.
Foreign Earnings Repatriation
Some implications are clear and immediate, like the potential for U.S. companies to repatriate earnings made abroad and enjoy those monies at home with a smaller IRS burden. The reduced corporate tax rate—from 35 percent to 21 percent—also makes the United States more competitive internationally as a business and investment destination.
“As firms pay less in taxes and have more money in their wallets, so to speak, as they repatriate assets from the rest of the world to the United States, what does this mean for their investment decisions and their hiring decisions?” asks Nathan Sheets, head of global macroeconomic research at PGIM Fixed Income. “If they do take steps to invest or increase their hiring, the tax bill could expand the productive capacity of the U.S. economy and allow the economy to continue to grow in a non-inflationary way.”
But Sheets also points to several red flags from the tax act.
The most grave, he says, is the U.S. debt situation. Sheets’ concern is that the legislation will add debt to the U.S. balance sheet at a time when “the U.S. fiscal situation is already in a very tenuous place.” It’s estimated to add up to $1.5 trillion of new burden on the economy over the next decade.
“It means that the supply of U.S. government securities into the bond market is going to be substantial, raising some questions about whether that will be digested and whether there might not be some increase in U.S. interest rates in various places along the curve,” Sheets says.
“The bottom-line here is, ‘How will companies respond?’ I really think this is the key question, and the answer is going to have major implications for equity markets, for fixed income markets, for exchange rate markets and, importantly, for the Federal Reserve as well.”
More octane for Wall Street
For equity markets in particular, Ed Campbell, a managing director with QMA’s Dynamic Asset Allocation Team, says the tax cuts will further fuel the rally in S&P 500 stocks. Financials, telecoms and small caps are poised to be the biggest beneficiaries, along with other domestically oriented segments that currently have high effective tax rates.
Even before the bill, corporate earnings were forecast to grow 11 percent in 2018, and the tax cuts could likely deliver an additional 5 to 6 percent.
“There was a positive story to tell about 2018 earnings growth even without corporate tax cuts,” says Campbell. “So the tax cuts are really the icing on the cake.”
In terms of its longer-term economic impact, congressional Republicans were betting that the incentives in the tax code, including the immediate expensing of capital expenditures for five years, will speed up investment and technology adoption, Campbell says. “If that happens, it’s likely to boost productivity and the economy’s long-run growth potential.”
“If investment stays sluggish, they are likely to get more inflation pressure than growth with the economy at full employment,” he adds. “And that’s a stagflation scenario. That’s not good for stocks or bonds.”
Status quo for real estate
For real estate investors, the legislation will likely have less of an impact than originally anticipated, according to Lee Menifee, head of Americas Investment Research at PGIM Real Estate.
As the tax bill made its way through Congress, there was a provision that would have eliminated the ability of commercial property owners to deduct interest income, which would have been consequential, says Menifee, because real estate is a highly leveraged asset.
“That provision didn’t make it into the final bill and, therefore, we expect this tax reform to mostly be a non-event for real estate.”
Still, there could be some niche benefits, which Menifee is monitoring.
“First is that we do expect the impact of this tax bill to moderately stimulate both corporate expansions and household spending,” he says. “The second is that the accelerated depreciation schedule for real estate is a short-term positive for investors, but they do raise the odds of overbuilding in some markets.
“Finally, and perhaps most consequentially, we don’t expect the impacts of this tax bill to be spread evenly across real estate markets. The limits on property, state and local tax deductions will have an impact on markets such as New York and California, and potentially tilt the balance in favor of more corporate expansions and population growth in lower-cost markets. Conversely, in those higher tax markets, the lower cap for mortgage interest deduction may be a positive development for owners of apartments.”
But Menifee expects all these impacts to be marginal.
“There will be many industries that will be profoundly impacted by this tax reform, including manufacturing and potentially healthcare,” he says. “We don’t expect real estate to be one of those industries.”
For more tax reform insights, visit PGIM’s tax reform page.
Are you a journalist interested in speaking with PGIM subject matter experts about tax reform? For Nathan Sheets, please contact Claire Currie. For Lee Menifee, contact Brendan Duffy. For Ed Campbell, contact Judith Flynn.
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