Now that the Trump tax cuts have been passed and US companies have had the opportunity to incorporate the changes into their projections, we are starting to see big payoffs. The financial sector will be a big beneficiary. But the corporate tax cut may also act as an incentive for companies to domicile in the US. In the absence of weakness in the real economy, these developments are supportive of further gains in share prices.
I am not going to write about the equity of the distribution of the tax cuts here except to note the cuts were overwhelmingly in favour of corporate cuts and cuts to higher income earners. What I want to point out is who stands to benefit most, now that we have a handle on what to expect.
According to the New York Times, banks are some of the biggest winners here.
JPMorgan Chase & Company, the nation’s largest bank, and Wells Fargo both said on Friday that they expected the new law to reduce their effective tax rates next year to 19 percent, a cut of nearly one-third from what they paid in 2016. The reduction will give the banks a combined boost of more than $7 billion in 2018 alone. PNC Financial said on Friday that it expected its effective tax rate to fall even further next year, to 17 percent.
As with the case of Walmart last week, we are seeing a ‘trickle down’ to households. More than 70 financial institutions have announced wages or bonuses increases in the wake of the tax law’s passage. The devil is in the details though because we cannot be sure how much of this trickle down to wage earners is attributable to a tightening labor market and how much to the tax cut bill. Nevertheless, the payouts to workers are only a small portion of the gains that banks will see. The lion’s share of the gains will accrue to retained earnings, dividends or share buybacks.
It is also interesting to note that community banks won with the tax cuts because about a third of community banks are organized as pass-through entities. And a provision to reduce tax rates for pass-through entities was included in the final tax cut bill. Republican Senators Ron Johnson of Wisconsin and Steve Daines of Montana had argued that pass-through companies would not get enough tax relief under the original Senate tax plan. Johnson intimated that he would oppose the bill as a result. In the end, the income tax deduction for pass-through businesses went up to 20% from 17.4%. And that was enough to address the Senators’ concerns.
In addition, accumulated foreign cash will now be taxed at a 15.5% rate and treated as ‘repatriated.’ Income invested in non-liquid assets like buildings will be taxed at 8%. These taxes are mandatory. And what that effectively means is that US companies with significant offshore cash are more than halving their deferred tax liabilities, which had been accruing under a 35% tax rate.
With foreign cash now taxed at a lower and mandatory rate, there is no tax reason to set up shop in Ireland and book all non-US revenues there. Now, you can simply run these revenues through the US.
Bottom line: US companies will see large benefits from the corporate tax cuts now going into effect. In an environment of relatively robust growth, this should increase earnings and make it easier for earnings multiples to expand. While banks will take a hit to earnings now due to the need for writedowns to their deferred tax assets resulting from previous losses, over the long-term, the cut in effective tax rates for banks will be one of the largest. Banks paid an average tax rate of 26% in 2016. That’s almost twice the effective rate for non-financial companies. With tax rates going down, financial services is one sector that will benefit most.