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Rekenthaler Report

Investment Implications of the Tax Bill

The silliest features were dropped, but two concerns remain.

Mentioned:

Getting Better All the Time
As time passed, the Tax Cuts and Jobs Act improved. Early versions of the bill contained several investor-unfriendly items. Chief among them were various suggestions for limiting 401(k) contributions, or perhaps swapping their current-year tax protection for future tax benefits (as Roth IRAs do); and a first-in, first-out (FIFO) requirement that would have eliminated investors' ability to specify tax lots when selling their securities.

The latter proposal was policy-making at its worst. For a very modest payoff--an estimated $2.4 billion over the next decade--the FIFO clause would have greatly complicated investors' lives by encouraging them to hold accounts at multiple brokerage firms. The huge institutional funds would have remained untouched. Harass everyday shareholders while bypassing Harvard's $38 billion endowment fund, staffed with dozens of well-compensated professionals? Genius!

Fortunately, Congress came to its senses when reconciling the House and Senate versions of the bill. Perhaps it was swayed by consumer outcry, as with this The Motley Fool article or my column from earlier this month. Or, perhaps, Congress realized on its own the hassle of collecting all those nickels and dimes. Whatever the reason, the legislation changed from clearly penalizing retail investors to possessing no direct ill effects.

(That last sentence is not completely true. The bill's full implications have not yet been realized, and rumors swirl that some mutual funds might be affected in this way, or certain stockholders in that way. However, these issues appear to be minor, and they likely would be cleaned up by a subsequent Technical Corrections bill to fix the legislation's small problems.)

There remain two open questions, however, as previously mentioned in this space.

Small-Plan 401(k)s
One is the future of small-company 401(k) plans. As Morningstar's Washington-based policy expert, Aron Szapiro, never grows tired of explaining, the United States (as opposed to most other countries) motivates employers to offer retirement plans by using the carrot of tax policy rather than the stick of mandates. Such an approach is philosophically appealing, in that it preserves the employer's free will, but it's only as effective as the tax incentive is strong.

And that tax incentive has been weakened. The bill's business-income deduction, which lowers the amount of income that is treated as taxable by those who own pass-through firms, is good financial news for those who own small companies. But it is bad news for 401(k) plan sponsorship, because business owners who invest in a retirement plan will receive a smaller tax benefit than in the past.

As Szapiro states, using the tax code to motivate investment decisions isn't necessarily the soundest policy. As the method is indirect, it can create unwanted side effects. However, cutting the influence of one source while not adding another source isn't the soundest policy, either. It can lead in only one direction: less action. Half of all American small-company workers lack access to a 401(k) plan. Following passage of the tax bill, that number figures to grow, not shrink.

The good news is that this problem can be remedied. Several organizations, including Morningstar, have published recommendations for how legislators could improve small-company 401(k) plans at little financial and social cost. The bad news is that Congress does not seem interested in expanding 401(k) coverage and is unlikely to attempt a fix.

(Matthew Kirk writes, "Let's get rid of 401(k) plans as they exist today. I have an IRA, as do many of my contemporaries. For employees who lack an IRA, open one for them unless they specifically opt out. Then it's entirely up to the employee to find funds and a brokerage that are suited to me, instead of sticking me with high-cost funds from the 401(k) committee's new best friends."

That would be an approach, although I think IRA contribution limits would need to be sharply raised. There are many reasonable paths to improving the small-company retirement experience. With almost no such firms offering traditional pensions, only half having 401(k)s, and the 401(k) plans that do exist holding funds with an average expense ratio of 1.5%, it would be hard not to improve upon the status quo!)

Home Affairs
The second open question is the amount of damage that limiting the property tax and mortgage deductions wreaks on home prices. This subject, I confess, confuses me greatly. Szapiro's analysis supports the National Associate of Realtors' estimate that average housing prices will drop by 10%, possibly significantly more. (On the bright side, it is possible that the housing market will adjust by building fewer new homes, which would ease the price pressures.) Once again, as with 401(k) plans, the federal government has removed a tax benefit without giving anything back in return.

So far, so bad. On the other hand, the houses that are most affected by the upcoming legislation are those with unusually high mortgages and property taxes--the type of houses that tend to be owned by investors. What the tax bill taketh in the form of taxable deductions, it giveth (and then some) in the form of higher stock prices. Reducing the corporate income-tax rate to 21% from 35% is rocket fuel for the stock prices of companies that pay something approaching the maximum rate.

(A case in point being your columnist's employer, which paid tax rates from 31% to 34% for six years straight, before subsiding last year to 28%. Morningstar's (MORN) share price has risen by 17% during the past three months, with much of that gain surely owing to the tax bill.)

In other words, those people most harmed by the tax bill's real estate features are among those most helped by its corporate provisions. Also, unlike the subprime mortgage holders who sparked the 2007 real estate downturn, the investor class of homeowners are relatively well-prepared to withstand home-equity losses. They are less likely to fall underwater with their mortgages and more likely to withstand that condition should they undergo it.

Finally, the size of the ripple effect is uncertain. Higher-end homes will surely decline in value, perhaps by large amounts. As this movement will compress real estate quotes, so that cheaper houses become closer in price to luxury estates, it's reasonable to assume that even houses that aren't directly touched by the new legislation may suffer indirect harm. Losses from the few may affect the many.

Or they may not. At the moment, all is speculation. Among the biggest 2018 investment stories will be how this speculation plays out, once the tax bill is signed (perhaps not until just after the New Year) and real estate deals begin to incorporate the new reality.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: MORN. Find out about Morningstar’s editorial policies.