After much debate and down-to-the-wire procedural drama, Congress ended 2017 by passing the most extensive revamp of the tax code in more than 30 years. While we’re still digesting the changes—and some of the actual rules are still being worked out—one thing is pretty clear: Cutting the corporate tax rate from 35% to 21% was big news for businesses.
Will it also be big news for your stock portfolio? That depends.
The short and long of it
The old top tax rate may have been one of the highest statutory rates among developed countries, but most investors are aware that each company bore that burden differently. Where some companies paid the top rate, others may have paid less, thanks to a variety of deductions and accounting adjustments.
The new lower tax rate could be a boon for those companies that were stuck paying the old rate. But the new law also rejigs or does away with some of the deductions that helped some companies lower their burden in the past. That could mean an adjustment period for some companies as they rearrange their tax strategies to suit the new rules.
When working out who the winners and losers might be, it can help to separate some of the short-term effects of certain provisions from the longer-term ones.
We’ve already seen some headlines from companies including Goldman Sachs and Bank of America announcing charges related to a provision that will slap one-time mandatory taxes on the trillions of dollars U.S. companies have been holding overseas (a result of an old rule that allowed companies to avoid U.S. taxes on any overseas profits until they were repatriated).
Some companies will also have to adjust to the fact that the new lower top rate decreases the value of “deferred tax assets,” or accumulated losses they could use to reduce taxable earnings. Some tech companies and banks still have quite a few such assets leftover from the tech bubble and 2008 financial crisis.
Could such changes be an issue going forward? Not necessarily.
“This doesn’t mean you should look to sell companies that could take a hit from these changes—but it is something to watch out for,” says Brad Sorensen, managing director of market and sector analysis for the Schwab Center for Financial Research.
Other provisions in the tax bill should have a more positive effect over the longer term. The following are among the more noteworthy provisions:
- Adoption of a “territorial” tax system. This will exempt businesses from having to pay U.S. taxes on most future profits earned overseas. Under the old “worldwide” system, businesses were on the hook for profits no matter where they were earned as soon as they repatriated them to the U.S.—which is why companies had been keeping so much money overseas. The new law will allow businesses to bring future profits home without having to worry about a tax hit, which will benefit companies and sectors—particularly tech and banks—that do a lot of business abroad. “We believe this will result in a fair amount of money being brought back to the U.S.,” Brad says. “At least some of that money will be used for capital expenditure purposes.”
- Immediate capital expensing. This will allow companies to immediately write off the value of any new capital investments, instead of having to spread it out over a number of years. “This could lead companies to make investments they’ve been putting off,” Brad says. “Beyond the immediate benefits to the companies themselves, this could also be good for tech companies as other industries make investments in tech-related gear.”
- Provisions for individuals could boost spending. Consumer-oriented businesses could also get a bump from increased consumer spending as the lower individual income tax rates could prompt consumers to shop more.
But some provisions could prove painful going forward. For example:
- Cap on interest deductions. This could hit companies—particularly the telecom sector—that have a large debt load. Under the old system companies could deduct interest payments from their tax bills. The new law limits such deductions to 30% EBITDA (earnings before interest, taxes, depreciation and amortization) for the next four years. After that, interest expenses above 30% of EBIT (earnings before interest and taxes) will no longer be deductible. “In our view, that could hurt high-debt shareholders in two ways: First, the higher tax expense due to the lower deductibility, and second, the potential for equity stakes to be diluted as companies issue more equity instead of debt to finance their operations,” Brad says.
Part of the puzzle
All things being equal, lower corporate taxes could mean larger profits and more capital spending. However, every company will be affected differently, so use these changes as a starting point when researching the impact on stocks. And don’t overreact.
“Investors should also avoid making any big changes to their portfolios just because of the tax law,” Brad says. “Taxes are just one factor affecting the performance of companies and stocks.”
What you can do next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.