The new tax cut bill will probably be approved very soon. This has made the bond market worry that stimulus will result in higher rates, thus hurting bonds. The ten year Treasury bond’s yield went up from 2.36% to 2.46% since yesterday, which is a significant move.
The stimulus will come in the form of personal tax cuts averaging $17 a week ($884 a year) for the average person in 2025. The tax cut will result in a gain of 1.2% in after-tax income, less than the 1.7% inflation rate. If the average person makes about $55,000 a year from employment that implies a tax cut of $660 attributable to employment income. This is not enough to stimulate the economy. Those who are burdened with debt will simply use it to pay off debt and those are wealthy will save it instead of spend it, thus the stimulus will be minimal. If the government mails a token tax rebate check to every taxpayer for a few hundred dollars in a recession most people simply deposit it and forget about it and thus don’t get motivated to stimulate the economy.
The raise in after-tax income reminds me of a boss who gave his workers a raise of 0.75% when inflation was 1.7% and they felt it was really a pay cut of 1%, after adjusting for inflation. The deficit attributed to this tax cut bill will increase by 0.75% a year, which after inflation, is actually a decrease of 1% a year. To truly stimulate the deficit spending would need to increase more than the rate of inflation.
Assuming that the leading edge of the big winning companies that are driving stock prices are the top 50 companies, mostly tech or pharma, these companies may actually experience a tax increase if they already moved most of their profits to offshore locations and will now have to pay 12.5% a year tax on those operations (instead of near zero now), plus a catch-up tax on previous years offshore earnings. The catch-up tax could be 200% of a year’s earnings for some companies. They may get permission from their CPA to claim that this was a one-time extraordinary item that should not be factored into the calculation of EPS. Thus stock investors may be fooled, at first glance, into ignoring the impact of the extra taxes. But ultimately investors will wake up to the fundamental truths and mark down the values of these companies. If investors anticipate that the Democrats will be in power in three years then the new tax law can easily be tweaked to change the foreign tax rate from 12.5% to 35% and then long range corporate after-tax income will drop steeply. Assuming the Invisible Hand of the market anticipates that then it should be built in the price now by the market (pushing stock down) and not three years later.
It is ironic that many stock bulls claim the alleged corporate tax cuts will prevent recession and stimulate stocks but instead what may happen is the top 50 companies including the ten FANGs stocks may have a higher tax bill thus reducing income and hurting stock prices. An important dichotomy exists in stocks where the giant companies have the lion’s share of corporate earnings and have less bubbly PE ratios than small caps, and the small cap companies that can’t afford offshore operations are often struggling with low income and ultra-high PE ratios. If a boost in after-tax earnings occurs mainly for struggling small cap companies that may mean a Russell 2000 small cap company with a PE ratio of 98 will have a PE of 81, but that is still way too high compared to a traditional PE ratio of 15. Small cap stocks are so overpriced based on PE ratios that even with a boost from tax cuts the stock prices still need a deep crash to reach fair value.
The single most important feature of the bill is that it ends the foreign tax free status of corporations and opens the door to infinitely higher taxes on foreign corporations owned by Americans. The original U.S. personal income tax was 4%. Then once people got used to it, the top rate was raised to 77% in WWI, then down to 20%, then up to 91% in WWII, then gradually down to 28% in 1988, then back to 39%, then 43.9% and so forth. So why not assume the 12.5% offshore corporate rate soon gets bumped up to 35% in 2021.
The bill’s anti-debt rules for corporations may encourage weak companies (that spend more than 30% of income on debt service) to issue more equity to pay down debt. This would dilute shares and thus lower stock prices and would reduce demand for borrowed money thus lowering interest rates.
Most of the action regarding stimulus would be acted on by affluent people who can afford to spend and who are not wealthy. The profile of these people is they live in high tax Blue states and earn a good living. They may pay $20,000 to $40,000 in state income tax and now they will lose almost all of that deduction since it will be capped at $10,000 to be shared with property tax deductions. This will mean some families will be paying a few thousand more in taxes than now. (The AMT rules now negate much of that deduction, so the shock may not be that bad, but it is still a consumption-repressing, job-killing tax shock.)
Investors need independent financial advice about the risks of being fooled by fake tax cuts.