U.S. Tax Reform Finds a Path Forward

On December 2^nd, the Senate voted to pass tax reform after making several amendments to firm up the vote count. While the content of the bill and the successful vote comports with our base case that the Republicans' tax reform plan will become law effective 2018, the Senate acted faster than expected, improving odds of a 2017 passage.

So what can investors expect now as we move toward a possible Senate/House conference committee, as well as a potential government shutdown and sequestration?

Here are 7 key takeaways:

Enactment of tax reform for 2018 affirms our thinking in 3 key markets: In U.S. equities, passage of the tax reform bill may help push markets higher on better potential earnings, but in the view of our U.S. equities strategists, once this is achieved the upside becomes limited. In corporate credit, passage may be a headwind for highly leveraged credits given limits to interest deductibility, supporting our cautious stance, particularly on low-quality high yield bonds. In U.S. rates, the modest near-term stimulus potential of the bill supports flatter curves and lower ceilings for Treasury yields.

Senate passage affirmed again that Republicans would stay within the constraints of the $1.5T budget allowance set up by the reconciliation process. Per the Joint Committee on Taxation’s score, the Senate bill holds 2018 deficit expansion down to $32B, or roughly .15% of GDP. While this number could change upon conference, it comports with our assertion that the tax bill is unlikely to provide a meaningful boost to 2018 growth.

As a late amendment to fund other modifications, the Senate-passed bill includes an Alternative Minimum Tax (AMT) for corporations at a full 20% rate. AMT was largely expected to be repealed for corporations, as it was for individuals. AMT functions as a parallel tax system that permits fewer deductions and credits. However, AMT has historically been applied at a rate less than the full statutory rate. By applying AMT at the full 20% rate, the mechanism may partially or fully eliminate other beneficial provisions. In particular, there is concern that the R&D tax credit—which would primarily benefit Technology, Healthcare and Industrials sectors—may be effectively nullified. This is likely an unintended consequence of last minute policymaking and may be subject to modification in conference—however at ~$40 billion over 10 years, it will be at the cost of another provision or the rate itself.

The Senate-passed bill aligns with the House bill by including 100% immediate expensing for corporate spending on qualified non-real property through 2022. However, the Senate bill extends a form of bonus depreciation with 80% up-front expensing in 2023, then scaling down to 20% in 2026.

For capital intensive companies, immediate expensing often results in companies spending into a taxable loss position. Losses are not immediately creditable but may be carried forward indefinitely under the Senate bill, however limited to 90% of taxable income through 2022 and 80% thereafter. As losses can take years to ‘earn back’, they often lose the time value of money and may restrict monetization of other subordinate tax credits that have shorter expirations. Research indicates companies often forgo electing bonus depreciation due to loss concerns. We would be more constructive on the efficacy of immediate expensing as a stimulus if tax writers allow tax carry forward losses to accrue an annual real rate of return as prescribed in the House bill (H.R. 1). 

One of the most frequent questions from investors is whether the final bill will adopt a taxable EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization) interest limitation approach for businesses.  

As the difference offsets over a +$100 billion over ten years, we think the bill’s final version will use the Senate's deductibility cap at 30% of EBIT, versus the House’s cap at 30% of EBITDA. The lower base will affect more companies and is marginally more pro-cyclical. 

In another effort to fund offsets, as predicted, the Senate increased the deemed repatriation rates on accumulated retained foreign earnings to 14.5% on cash-backed earnings and 7.5% on all other earnings, from 10% and 5%,  respectively. This is largely in line with the House bill at 14% and 7%, respectively. 

Investors should closely monitor reconciliation of House and Senate base erosion protection provisions while in conference. While both chambers attempt similar objectives with similar mechanisms, there are pros and cons to each approach among all provisions. In particular, we highlight an overlooked provision in the Senate bill that would allow U.S. multinationals an effective rate of 12.5% on intangible income exported from the United States. This policy would primarily benefit Technology, Biotechnology, Pharmaceutical, Industrial and Media industries.

There are several key risks to our base case. First, there are disagreements between the Senate and House versions of the bill that will need resolution in the conference committee process. Removing the Affordable Care Act's individual mandate and keeping in personal AMT may draw opposition from moderate Republicans in the House, though perhaps not a significant number. Meanwhile, the temporary nature of personal cuts may upset some conservatives. Our base case is that these differences are not fatal, particularly given the demonstration of determination to overcome hurdles and pass tax reform.

Another consideration is the market implication of the “Pay-as-you-go Act” (PAYGO) rule which requires that new legislation enacted during a Congress not increase estimated deficits above current levels.  If the Office of Management and Budget (OMB) finds an “indication” of increasing deficits, then they must order a sequestration—another word for across-the-board spending cuts. However, PAYGO exempts many categories of spending from sequestration. For example, it restricts sequestration cuts to Medicare to a maximum of around $25 billion per year. But that still leaves about $80-90B of spending to restrict per the sequestration rules. This can have implications for markets.

For now, we're watching PAYGO risks rather than making them our base case. For one, it appears that only OMB can declare a sequester, and it is conceivable they could delay doing so or refuse to do so altogether. In addition, this is only an issue if tax reform is signed this calendar year. If tax reform is not signed until 2018, PAYGO would not be an issue until 2019.  Further, Congress, as it typically does, could “fix” these PAYGO issuers before they took effect, possibly as part of a year-end spending deal.

Finally, there is the risk of government shutdown. 

Current funding runs out on December 8th, but we expect the real shutdown risk to emerge at the beginning of January. Republicans plan to pass a two-week clean continuing resolution (CR) until December 22nd. They then plan to negotiate the top-line appropriations numbers for the Budget Control Act caps and pass another CR lasting until mid-January, giving the appropriations committees time to finalize their bills for passage.

We think Democrats will go along with this planned timing, but may demand concessions in other areas like border wall funding. That said, while the faster-than-expected movement on tax reform should mean that such drama shouldn't spill over into finalization of tax policy, there is a risk that these items could hold up the approval process.

For Morgan Stanley Research on the implications of U.S. Tax Reform, contact your Morgan Stanley representative or Financial Advisor.  Plus, more Ideas.