Tax reforms in the US are back on the agenda but investors and economists remain split on what impact they will have on the S&P 500 index.
The US blue-chip index rallied after Donald Trump was elected president at the end of 2016, owing to the fact he had made a number of pledges aimed at stimulating the economy.
However, difficulties experienced by Trump in pushing through healthcare reforms earlier this year pared back expectations of drastic tax cuts.
But new tax reform proposals were published at the end of September and investors have begun to anticipate what it could mean for the S&P 500.
Performance of S&P 500 sectors over 1mth
Source: FE Analytics
The latest proposals put forward by Donald Trump’s administration include a cut in the standard rate of corporate income tax from 35 per cent to 20 per cent. A second proposal limits the deduction of net interest expenditure, while a third would change the way that multi-national companies are taxed.
“Overall, the changes would boost the earnings of companies in the S&P 500,” said Josh Higgins, chief markets economist at consultancy Capital Economics.
Higgins said the proposals had been positive for cyclical areas of the market, which have performed better than their counterparts in the defensive sector.
As the above chart shows, the S&P 500 Energy sector has been the best performer over one month, along with financials and industrials. The utilities sector was the worst performer loser along with real estate and consumer staples.
“Excluding buybacks, the current tax plan could boost recurring earnings for discretionary, staples and financials by 5-6 per cent due to their high tax rates, while real estate and utilities would be minimally impacted,” noted Bank of America Merrill Lynch.
“Given their high overseas cash balances, tech and healthcare would likely benefit most from the repatriation tax holiday, as these sectors could buy back 6 per cent and 3 per cent of their shares, respectively.”
“The long-awaited unveiling of Trump’s tax reforms puts tax back at the forefront of US investors’ minds. A significant drop in corporation tax is an immediate benefit to share prices,” wrote Nick Ford and Hugh Grieves of the Miton US Opportunity fund.
“Further out, cutting consumers’ tax bills at the expense of running a higher fiscal deficit is also highly reflationary, and a positive boost to corporate earnings.”
While the proposals are likely to gain approval, thanks to the Republican party majorities in the both the House of Representatives and the Senate, they could face other challenges.
“A US tax reform, if it materialises, is likely to be modest in size due to constraints on funding following the failure to repeal Obamacare,” said Ashmore’s head of research Jan Dehn (pictured).
“Besides, the tax cut is more of a fiscal stimulus than a reform per se in that it looks set to add more to the US debt stock than to the trend growth rate.”
The tax cut proposals also come as the US debt ceiling is revisited in December. While Republicans have more recently opposed raising of the debt ceiling, they are likely to be more conducive, particularly as tax cuts are forecast to reduce revenues by $2.2trn over 10 years.
“That would need to be funded with more borrowing – awkward for Republicans who have made careers out of damning debt,” asset manager Rathbones noted in its Q4 outlook.
“Their defence? Reforming the tax code and lowering rates will lead to a boom in economic growth that will increase the tax base so much that it will lead to greater revenue.”
However, some in the industry have warned that any tax reform may not meet investor expectations particularly as Trump was unable to axe Obamacare after running into opposition from both sides of the political divide.
Despite the argument that tax cuts will ultimately lead to greater revenues, the impact on the S&P 500 is likely to be limited, however.
Capital Economics’ Higgins said: “Although the Republicans’ proposals would raise aggregate S&P 500 earnings, this boost may have already been largely priced into the market.
“After all, we estimate that the median effective tax rate paid by companies in the index last fiscal year was nearly 28 per cent.
“If it had been 20 per cent, operating earnings per share would only have been about 10 per cent higher. The S&P 500 has already risen by more than that so far this year.”
Performance of S&P 500 over 2017
Source: FE Analytics
As the above chart shows, the S&P 500 has already risen by 13.72 per cent in US dollar terms during the first nine months of the year.
Indeed, the continued rise of the index has prompted concerns about US stock valuations and posed questions over how much further room there is for growth.
Capital Economics’ Higgins added that he found it “hard to see why the S&P 500 should continue to rise sharply, given that much of its strength so far in 2017 appears to have relied at various times on the prospect of tax reform, the passage of which remains uncertain”.