Tax Reform’s Impact On ETFs, Economy

After months of anticipation and political wrangling, tax reform is finally here. Well, not officially―the House of Representatives and Senate must come up with a compromise bill that can pass both chambers of Congress before President Trump can officially sign it into law. But if Republican leaders are right, they can come up with a consensus bill in time to pass it before the end of the year.

There are some key differences between the Senate and House bills that the conference committee tasked with coming up with a compromise must negotiate. For example, tax cuts for individuals would expire in 2025 under the Senate bill, but would remain permanent under the House bill. The Senate bill has seven tax brackets, while the House bill only has four. Under the Senate bill, corporate tax cuts don't go into effect until 2019, one year later than the House bill.

All those differences and others must be ironed out before the final bill can be passed. That means the ultimate form that tax reform takes is yet to be determined. Still, there's enough common ground between the Senate and House versions of the bill to make an assessment of how the law may impact the economy and markets.

Limited Growth Impact?

Economists and analysts are wasting no time in chiming in with their views. Professional economists are divided on whether economic growth will pick up meaningfully following the tax cuts. Many economic models suggest the growth impact won't be very large.

The Joint Committee on Taxation, a congressional group that investigates all things related to taxes, estimates the Senate version of the bill would lift gross domestic product by only 0.8% over the next 10 years, while increasing the deficit by $1 trillion.

Meanwhile, Goldman Sachs economists said this week that the tax cuts would have a meaningful near-term impact, lifting GDP by 0.3% in 2018 and 2019, but little to no impact beyond that.

Joe LaVorgna, chief economist at Natixis, agrees that the tax bill won't do much to accelerate growth. He told CNBC that "the reason it won't work is the corporate already has a very high profit share to GDP."

"That's not saying corporate tax rates shouldn't come down and there shouldn't be removal of loopholes. But to sell this as a stimulus package is absurd,” he added. “Companies have the money to spend; they're just not spending it. They're buying back stock. They'll do more of that."

Deficit Increase 'Drop In The Bucket'

Of course, the tax bill is not without its supporters, who believe reform can boost annual U.S. GDP growth from the 2.1% rate it has averaged since the financial crisis to 3% or more. Last month, 137 economists signed an open letter to Congress in support of tax reform, saying it will “ignite our economy with levels of growth not seen in generations."

One of those economists, Douglas Holtz-Eakin, former director of the Congressional Budget Office and president of the American Action Forum, told the New York Times the economic logic supporting the tax cuts is "straightforward and time-tested."

"Better incentives—like lower tax rates, being able to write off investments, taxation only on earnings in the U.S.—will encourage innovation, investment, hiring and pay raises,” he said. “These incentives increase the accumulation of capital, whether in physical equipment or intellectual know-how."

Holtz-Eakin also pushed against the idea that larger deficits due to the tax cuts will have much of an impact on the economy.

"The Treasury will need to finance another $40 billion to $60 billion more each year. This is a drop in the bucket of the Treasury market, with inconsequential implications for the overall level of interest rates," he explained.

Corporate Profit Surge
While opinions on the tax bill's impact on the economy are divided, they are nearly unanimous on its impact on another area—the stock market. Analysts across the board believe the cut in the corporate tax rate is unequivocally bullish for U.S. stocks as a whole.

Under both the Senate and House bills, the rate would decline from 35% to 20% (President Trump hinted the final rate could be as high as 22%).

Keith Parker, chief U.S. equity strategist for UBS, believes a cut in the corporate tax rate to 20% could lift earnings for S&P 500 companies by 9.5% on top of the double-digit growth already expected. If that happens, the stock index could rally to 3,300 next year, up 25% from current levels.

David Kostin, chief U.S. equity strategist for Goldman Sachs, has a slightly less bullish view, but still sees earnings rising by 14% and the index rallying to 2,850 next year on the back of the tax cuts.

Likewise, Chief U.S. Equity Strategist for Credit Suisse Jonathan Golub believes consensus 2018 earnings-per-share estimates for the S&P 500 would jump 14.3% if tax cuts go into effect.

"While the current statutory rate is 35%, companies are paying only 27%, on average," he said. "While specifics are unclear, investors are presuming the new effective rate will move toward 20%. If the change goes into effect in 2018, consensus EPS would jump from $146 to $160." Golub currently has a 2,875 year-end target for the S&P 500 in 2018.

Industry Impacts

The most obvious ETF beneficiaries of tax reform include broad-market U.S. equity funds such as the SPDR S&P 500 ETF Trust (SPY) and the iShares Russell 2000 ETF (IWM). The two ETFs gained 19.8% and 14.1%, respectively, so far this year in part due to anticipation of tax cuts. But if analysts are right about earnings, they could run further in 2018.

Among industries, banks, transports, health care services, retail, and telecommunications stocks may see the largest earnings gains due to their domestic focus and high effective tax rates, according to an analysis from Reuters.

The SPDR S&P Bank ETF (KBE), the iShares Transportation Average ETF (IYT), the iShares U.S. Healthcare Providers ETF (IHF), the VanEck Vectors Retail ETF (RTH) and the Vanguard Telecommunication Services ETF (VOX) are a few ETFs targeting those areas.

On the other hand, industries with already-low effective tax rates may benefit the least from tax reform. Those include tech, pharmaceuticals, biotechnology and real estate investment trusts, according to Credit Suisse.

Contact Sumit Roy at [email protected]