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Stock Strategist Industry Reports

Latest Tax Reform Plan Just a Starting Point

The unified framework doesn’t change our fair value estimates or moat ratings.

We view the unified framework for tax reform, released Sept. 27 by the Trump administration, the House Ways and Means Committee, and the Senate Finance Committee, as a starting point for tax reform negotiation; we don’t think it’s truly representative of what an eventual tax reform bill may look like.

This 9-page framework is similar to other guiding-principle documents about tax reform, like the 35-page House Republican Better Way blueprint and the 1-page outline from the White House. Items in the previously released guidelines--such as the border adjustment tax in the blueprint and the 15% corporate tax rate in the White House outline--appear to have fallen by the wayside, so we anticipate adjustments to this framework, especially as the details are filled in.

We continue to believe that tax reform during the Trump administration is more likely than not to occur and that the tax reform assumptions we’ve incorporated into our valuations are a reasonable approximation of what tax reform will ultimately look like. Therefore, we don’t plan to make any changes to our economic moat ratings or fair value estimates as a result of this announcement.

One of the guiding principles for what we think plausible tax reform will look like is that it’s close to deficit-neutral after taking into account economic growth stimulated by tax reform. The unified framework looks similar to the House Republican blueprint, except it doesn’t include the border adjustment tax, which was estimated to raise approximately $1 trillion of revenue. Without the border adjustment tax, this framework would probably lead to a material increase in the public debt. One of the largest levers that Congress could pull to make this framework closer to revenue-neutral would be to only lower the corporate tax rate to 25%, which is what we’re assuming, instead of the 20% in the framework.

Other areas in the framework that at least partly differ from our tax reform assumptions are the move to a territorial tax system, a specifically mentioned tax credit, and the permutation for the treatment of net interest expense and expensing of capital expenditures. The move to a territorial tax system, where a company is taxed only in the jurisdiction where it generates earnings, from a worldwide tax system like in the United States, where U.S. companies are taxed on their U.S. earnings and the foreign earnings that they repatriate, is a dramatic change to the tax system and arguably could bog down tax reform discussions when members of Congress probably want something done by the 2018 midterm elections.

From a valuation point of view, a move to a territorial system shouldn’t materially affect our fair value estimates, as many companies permanently reinvest their foreign earnings to avoid paying taxes on those earnings. We note that it’s an open question whether it’s a complete territorial tax system, as the framework also mentions a way to still tax the foreign profits of U.S. multinational corporations at a reduced rate.

The framework has some adjustments from prior guidelines that partly fall in the “revenue raiser” category. All of the previously released guidelines and our own outlook include the assumption for reducing or eliminating certain special interest tax provisions. For corporations, only the Section 199 domestic production activities deduction was commonly cited as being earmarked for elimination; the research and development credit was mentioned as being preserved. This framework also states that the low-income housing credit is seen as being aligned with policy goals and should be preserved.

We had assumed that U.S. manufacturing capital expenditures would be allowed to be fully and immediately expensed if the company elected to also give up its net interest expense deduction. The framework proposes to allow the full and immediate expensing of new investments in depreciable assets for at least five years and a limitation on net interest expense for C-Corporations. The full expensing of depreciable assets for five years is an interesting idea that serves at least two main purposes. First, by sunsetting the full expensing, it will help the budget-neutral aspect of tax reform if it’s passed via budget reconciliation procedures. Second, full expensing during the first five years after tax reform is enacted should front-load the related economic stimulus. Capping the amount of net interest expense on corporations will help raise revenue but could be too controversial to include in a final bill, as it penalizes companies that use a lot of debt in their capital structure.