Time to Talk About Tax Reform

Important reminders go on Post-it notes. Photo by alfexe/iStock by Getty Images.

President Donald Trump made an unscheduled trip to Texas on Tuesday to support those afflicted by Hurricane Harvey. However, the president's return flight to Washington wasn't nonstop-he had a layover in Missouri to kick off and rally support for the GOP's big tax reform plan. White House officials and GOP congresspeople have squawked about "simplifying the tax code" for a while, and media have fired off loads of analysis in response. As we monitor the latest, we remind investors to not overstate every "breaking news" development-not only is tax reform difficult to accomplish, but it isn't automatically bullish even if it becomes reality.

A group of White House officials and congressional Republicans known as "The Big Six"^[i] have led the charge for the GOP's current tax reform plan. On the individual side, the plan keeps popular deductions like charitable donations, mortgage interest and retirement savings. The first two are especially common: According to the IRS, out of the approximate 44 million individual returns with itemized deductions in 2013, 82% claimed charitable donations and 77% claimed mortgage interest.^[ii] The plan also wants to raise standard deduction caps-among other personal deductions-while getting rid of estate taxes (colorfully known as "death taxes"). On the corporate side, the GOP is proposing a lower corporate tax rate (level unspecified) as well as a "territorial system" so American corporations won't pay more taxes when bringing future foreign profits home. (They are also pitching a holiday for companies to bring back profits held abroad at a special low-low rate.) Congress's House Ways and Means Committee is shaping the legislation while Trump tries to rally support for the plan. The goal: passage this year.

Though leading Republicans are optimistic, passing a tax reform bill won't be easy. Politically, the GOP doesn't have much wiggle room. In the Senate, Republicans hold a thin 52-48 majority, and they have to contend with both Democratic opposition and GOP dissenters-any defections could torpedo efforts. (And even then any proposal will have to be temporary, as 60 votes are needed for permanent tax code changes affecting the deficit.) However, the outcry isn't surprising: Tax reform means changing the rules, and the adversely affected will be the most outspoken opponents.

Obviously, those benefiting from imperiled deductions are up in arms. For instance, the federal deduction for state and local taxes, which isn't on the "safe list," saves many taxpayers from double taxation. However, it tends to favor folks in states that require the highest combination of property taxes and individual and corporate income taxes (e.g., California, New York, Ohio, Virginia and Texas^[iii]). Also, debt-issuing corporations are closely watching for potential revisions to bond interest payment deductibility rules, which many companies use to reduce taxable income. Removing this deduction could motivate firms to borrow outside the US.

But opposition doesn't stop here. Even seemingly benign changes like doubling the standard deduction are generating a sharply negative reaction from groups whose deductions aren't on the chopping block. For instance, realtors, home builders, mortgage lenders and charities fear increasing the standard deduction discourages itemized deductions-meaning less reason to carry a mortgage or give to charity.^[iv] While nothing is finalized, lobbyists, interest groups and politicians representing those with something to lose are out in full force.

This is why tax reform-even the allegedly "business friendly, GOP-style" variety-isn't inherently positive for companies or their stock. Tax changes create new winners and losers. If comprehensive tax reform benefited all, we are pretty sure politicians would have done it already. They are in the business of getting elected and reelected, and if you give them a surefire way to win votes, they'll do it. However, while tax reform beneficiaries may like their perks, the disadvantaged will dislike the new reality much more-about two-and-a-half times more, per prospect theory.

More notable for investors, history demonstrates tax hikes or cuts lack a set market impact. As we showed in "The 2016 Candidates, Taxes and Your Portfolio"-posted on our sister site Market Insights-"the enactment of tax changes rarely had much predictive power about where stocks headed thereafter." Because tax policy is so widely scrutinized, any and all debate allows markets to adjust and price in the various potential outcomes. Beyond the wide discussion, tax changes usually get implemented over time rather than immediately. This slow, deliberate pace saps surprise power and gives stocks a good idea of what they're dealing with. Surprises move markets, and the public's laser focus on taxes likely means reality surprises few.

Despite all the hubbub and theory otherwise, stocks haven't climbed this year because of potential tax reform-they are up because of underappreciated drivers like a growing global economy, gridlocked governments and warming investor sentiment. By extension, they shouldn't flounder even if tax reform efforts fall flat. We will keep a close eye on the latest developments, but don't get caught in the hype. Focus instead on what actually happens. Tax debate can get loud and messy, and the outcome will affect certain swaths of taxpayers. However, don't overstate the market impact.