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Aon Hewitt Retirement and Investment Blog

Will “The Tax Cuts and Jobs Act” Have Unintended Consequences?


The Tax Cuts and Jobs Act (TCJA) was finally passed on December 20th. The end result is similar to the outcome that we had anticipated back in our October note with the total impact on the deficit, $1.8 trillion over the next decade, when including additional debt service costs. This is slightly higher than the levels indicated by Congressional Republicans as acceptable. Whilst there has been some modification to the White House’s original plans the essence is unchanged: this is a substantial fiscal stimulus aimed predominantly at the corporate sector. The consensus amongst economists is this will have only a moderate impact on 2018 growth through slightly higher consumption, limited by the majority of the gains going to richer households who are less likely to spend. However, as the equity market has already capitalized the net present value of the additional tax benefits, we think the boost to household net worth may mean that there will be a slightly larger impulse than believed. However, could there be unintended consequences that the market has yet to digest?
What finally got passed?

  • The final version of the TCJA has kept most of the key features that we previously highlighted, although there has been some moderate scaling back as well as some revenue raising measures. For corporates this means:
  • A cut in corporate tax rates from 35% to 21% rather than the 20% originally planned.
  • Rather than allowing depreciable capex to be fully deductible, “bonus depreciation has been raised to 100% from 50%.  This will mean that for an asset which is to be depreciated over 5 years, 40% rather than 30% of the cost will be able to be deducted in year one, this increases the net present value of the depreciation deductions and increases the attractiveness of investment. The more an asset is financed with equity and the longer its life the greater the value of this shielding.
  • The plans on interest deductibility have evolved into a limit of 30% of EBITD (earnings before interest taxes and depreciation).
  • A partial shift from a worldwide to territorial tax system, however, there will be a tax of 10.5% on “excess” returns on tangible investment in order to discourage shifting intellectual property  overseas, as well as an alternative income measure, which excludes payments to overseas affiliates, with a tax of 10% to discourage aggressive transfer pricing.
  • There are also some “one-off” measures including tax on retained earnings overseas 
For households:
  • Top rate brought down to 37% (from 39.6% and versus 35% planned), and the 35% band widened.
  • The number of federal personal income tax bands in the end remained the same. The $0 to $9,325 income band (for a single filer) had been planned to be eliminated effectively raising the rate to 12% (from 10%) but this band has now been retained.
  • Limits on allowed deductions. Most importantly the state and local tax deduction is now limited to $10,000. This impacts middle and higher earners in higher tax states and municipalities and could put pressure on weaker municipalities, whilst we flagged this as likely these did not form part of the original White House plans. Limits on mortgage interest payment deductions and out-of-pocket medical costs.
  • The Alternative Minimum Tax (AMT) now kicks in at a higher level ($1 million for couples).
  • Plans to abolish inheritance (estate) tax were dropped although the threshold was doubled to $11.2 million for individuals ($22.4 million for couples) making it applicable only to the very largest estates. 
Impacts on growth

For the fiscal year 2019 (which starts in October this year) the Act will add 1.4% of GDP to the fiscal deficit according to the latest CBO projections published 2nd January. Translating this in to calendar years suggests around a 1.1% of GDP fiscal boost for this calendar year versus the previous law. JP Morgan (J.P. Morgan, 2017)[1] suggests that this will boost growth by 0.3% in 2018. This might seem surprisingly low for such a big stimulus but is in part a function of most of the benefits accruing to higher income families with a lower marginal propensity to consume from additional income. However, it is possible that the boost to the stock market from the tax cuts, (markets over the course of 2017 added the net present value of expected tax savings to the value of the market) will have additional wealth and sentiment effects that will make the boost to growth slightly greater than the market is expecting.
Defense and disaster relief to have a bigger impact?

It is not just the TCJA which will likely lead to easier fiscal policy. Most economists also anticipate that defence spending will rise and that there will be further disaster relief for the areas impacted by hurricanes last year. Added together economists are typically looking at a “fiscal impulse” of around 0.5% to growth. Whilst we agree that the additional spending is likely it is not yet a certainty and could be derailed by Congressional fiscal hawks.
Are economists behind the curve?

Does this mean economists will soon be revising up their 2018 GDP forecasts? Consensus economics undertook its last survey on the 4th December, and their mean forecast for 2018 was 2.5%. We think that by then much of the TCJA, as well as the expenditure increases was anticipated and factored in. Whilst there are more recent forecasts available in the Bloomberg survey there has been no significant increase in the average forecast which has been updated since the tax reforms were passed. We think that for the plan to have a much greater boost to growth than economists are expecting there must be a feedback loop into “animal spirits”. Given the strength in equity markets we believe that this is quite likely. This suggests that the risk to US forecasts is on the upside, and a consensus view of around 2.7% would be reasonable. This is faster than potential GDP growth of around 2%. Whilst at the margin this will help inflation accelerate towards the Fed’s desired levels (2% on the PCE deflator) we don’t think that inflation will significantly overshoot.
Buy the story and sell the fact?

Whilst there may be some small upside to growth forecasts, we believe that the direct impact of lower tax rates on after-tax earnings is now priced into equity markets at the aggregate level. When the legislation was finally passed the market drifted slightly lower suggesting that the TCJA might be a “buy the story, sell the fact” type of event.
Whilst we think that sell-side estimates that the boost to earnings per share (“EPS”) will be in the region of 7% are reasonable (JP Morgan for example are at 7%), this is typically done to a “base” estimate of EPS for 2018 which would already assumes substantial growth in EPS versus 2017 (for example JPM adjust “consensus 2018 EPS” of $146 to get to their target of $156 for the S&P*). With the market at 2730, this suggests that the market is probably already assuming that kind of level of earnings. Momentum may keep the market going for a while but overall we think that it is looking increasingly expensive.
Given the boost to growth and increased supply it is unsurprising that Treasuries have sold off since September with the 10 year rising from 2.04% to 2.47% at the time of writing. As we think the impact on inflation will remain contained we don’t think that there will be an extreme sell-off in bonds. However, as has been the case for some time we still think that bonds are not quite pricing in all the rate hikes that will be necessary.
Performance of the USD and credit has been arguably more puzzling. The USD has been weak since the start of 2017 and after a small pause in September and October has continued on its downward trend. We would normally expect that fiscal stimulus, particularly when economic slack is tightening, to boost the currency. It makes the Fed more likely to need to tighten. Rates markets are pricing in two hikes, with the Fed’s “dot plot” and economic consensus suggest three hikes. If growth ends up as being rapid as equity markets appear to be implying then the risk is that it could be as many as four hikes with more in 2019. Therefore for the first time since the Global Financial Crisis the risk to central bank rates forecast is more symmetrical with the possibility that the Fed might need to move faster than anticipated rather than delay because of adverse shocks or stagnant demand. 
The direct effects of the corporate tax changes are a marginal positive for investment grade credit and a slight negative for high yield. Limits on interest cost deductions will impact the more levered high yield issuers reducing free cash flow coverage. Despite this credit spreads have continued to tighten, even whilst US equity markets have paused, suggesting that strengthening commodity prices and increased confidence in global economic conditions are more important drivers.
Implications for markets

What does this mean for investors? We believe:
  • The US equity market has now priced in the boost to earnings. We will need strong pre-tax EPS growth to deliver significant further upside from here.
  • Despite this we still prefer equities to rates, particularly outside the US.
  • Inflation is likely to trend upwards over 2018, as the economy grows above trend. Depending on how the Fed reacts to this, the upward trend in TIPS break-evens, which has been in place since June, will likely continue. However, there is a risk that the new personnel at the Fed strike a more hawkish stance, it is possible that markets may fear that the Fed could overreact and this will reverse.
  • For the time being, the expected small boost to growth is supportive of global equity markets and risk assets. Provided the rise in bond yields is slow, this should encourage investors to rotate out of fixed income and in to equities. However, if the rise in yields was to become disorderly, there would likely be adverse impacts on equity markets.
Derry Pickford is a Principal on Aon Hewitt’s Global Asset Allocation team, and is based in London, UK.

[1] J.P. Morgan, U.S. Tax Reform: Tax Reform to Drive Equity Upside and Continued Rotation (December 20, 2017)

*S&P 500 - A capitalization-weighted stock index consisting of 500 of the largest publicly traded U.S. stocks by capitalization.

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