Recently released tax reform proposals from both the House and Senate are being scrutinized by politicians, investors, and corporations alike. As the bill works its way through Congress, many changes are likely; but, for now, we’ll focus on which equity segments are likely to benefit most from a lower corporate tax rate.
Overall, companies that generate the most revenue domestically, namely small cap stocks, tend to pay higher effective tax rates. And with corporate tax reform a key tenet of President Trump’s presidential campaign, it’s no surprise that the Russell 2000 Index spiked following his election victory, as well as in early September when a government spending bill was passed that paved the way for Republican lawmakers to focus on their pursuit of tax reform. However, recent news suggesting that the implementation of a reduction in the corporate tax rate could be delayed until 2019 has dampened investors’ enthusiasm.
Though large cap stocks likely won’t benefit from corporate tax reform to the extent of their smaller counterparts, looking at the total tax paid by S&P 500 companies’ as a percentage of their income suggests that a reduction in the highest marginal tax bracket to 20%, if enacted, would benefit all sectors. Per Ryan Detrick, Senior Market Strategist, “Some may benefit more than others, but when tax rates go down, everyone wins to some extent.” As the chart below shows, the telecommunications services and utilities sectors, which operate almost exclusively in the U.S., currently have the highest effective tax rates. Meanwhile, the information technology sector, which generates less than half of its revenues in the U.S., already pays a below-average rate yet would still benefit if the top marginal rate is reduced to 20%. One outlier is the real estate sector. Due to the corporate tax-exempt structure of real estate investment trusts, it already has a significantly lower tax bill than the other sectors.
The road to a final tax reform bill is sure to be bumpy and winding with the potential for market-moving headlines. Our view is that these kinds of headlines are part of the nature of the process. Some of it is genuine debate, some of it is establishing negotiation positions, and some of it is grandstanding for political cover before ultimately going along with the bill. We view growing skepticism as a potential opportunity to add some asset classes sensitive to tax reform at a more reasonable price.