How Corporate Tax Reform Could Affect Earnings

President-elect Donald Trump has proposed corporate tax reform as a means of promoting growth and improving the business environment for U.S. companies, highlighted by a reduction of the federal corporate tax rate to 15% from the current 35%.

For investors, retaining a greater share of pretax profits is an attractive proposition, but will tax reform benefit certain sectors more than others? And how much of an impact would these policy shifts have on the broad market?

To answer these questions, let’s examine the levels of taxes paid by companies in different market sectors. While the 35% tax rate does apply to the majority of publicly traded corporations, companies typically seek to reduce their tax bill through deductions. We calculated the percentage of pretax profits paid in taxes in the trailing 12 months.

In aggregate, U.S. companies paid tax at a 21.5% rate (see chart below). Consumer staples, consumer discretionary and telecom companies have paid at rates in excess of 25% as their businesses generate fewer deductions. These higher tax-paying sectors would realize the largest benefit from a decline in the marginal tax rate. 

Trailing 12-Month Realized Corporate Tax Rate

On the other hand, real estate companies that benefit from corporate tax exempt real estate investment trust structures, and utilities that enjoy deductions from depreciation related to large capital spending needs already pay very modest tax rates. Thus, they are unlikely to see substantial benefit from further rate reductions.

Secondly, how much earnings benefit would broad U.S. equities see from a 15% corporate rate? While the interplay of tax rates and corporate earnings is complicated, we performed a simplified analysis: first, we looked at sector-specific earnings expectations for the S&P 500 companies for 2017.

Next, we examined the potential effect of the tax rates embedded within those expectations shifting from the rate of the past year to a flat rate of 15%.

As given in the table below, sectors with highest tax rates stand to reap the greatest benefit, with consumer staples seeing a rise in earnings per share of more than 20%; likewise, sectors with lower tax rates see a negative effect. In total, the S&P 500 gets a significant 8.2% benefit in earnings per share.

Sectors with Highest Tax Rates Stand to Benefit

Given the nature of the legislative process, tax reform will take time. But lower corporate tax rates may yield benefits for investors, and the outperformance of companies paying high tax rates postelection suggests market confidence in their ultimately becoming policy.