Kevin E. Thorn
Tax reform efforts are underway by the U.S. Congress, although the success of tax reforms is far from certain. Reforming the U.S. tax code could be one of the keys to continuing the stock market rally of 2017. Tax reform, if passed, could help stocks to continue trading at record highs. Here’s a list of the reasons why.
Companies have seen high profit margins in 2017, and those profit margins are likely still rising. High profit margins have generated 10.2 percent growth on the S&P index during the second quarter of 2017. This 10.2 percent S&P growth occurred even as there was revenue growth of just 5.1 percent. The stock rally this year has largely been caused by incremental margins generating positive earnings surprises, even though revenues were forecast accurately by the market. However, looked at in a larger historical context, there is a big risk that margins may revert back to longer-run averages, especially as the trailing fourth-quarter S&P 500 operating margins were at 10.6 and 10.8 during different quarters in 2017.This is compared with under 8.0 percent in the 1990s and 9 percent in 2006, when these margins hit their previous peak. Corporate tax reform could serve as a counterweight if corporate margins, on average, revert back to longer-run averages.
Apple has $246 billion offshore, or 29 percent of the company's market allocation held by foreign subsidiaries. Apple is just one of many companies keeping funds in foreign locales instead of bringing profits back to the United States and paying taxes on them. Apple, and many other corporations with billions offshore, need to be able to bring this money back and distribute it to shareholders so it can be effectively used to invest in other businesses. Tax reform that includes corporate repatriation provisions could make this possible.
The U.S. has a corporate tax rate of 35 percent, which is one of the world's highest. Rates need to be cut to be more competitive with other developed countries. Tax reform proposals all involve cutting corporate tax rates. President Trump has pushed to cut the corporate tax rate to 15 percent, but many experts believe 20 percent is a more realistic outcome from tax reform.
Large companies pay lower effective rates than statutory rates under the complexities of the current tax code. The playing field must be leveled between big corporations--which can use tax reduction tricks to lower what they pay in corporate taxes--and smaller companies, which typically grow faster but which cannot take advantage of global tax havens to pay less in taxes. Lowering rates and closing loopholes, which are planned for tax reform, would accomplish these goals.
The Russel 2000 is underperforming the S&P substantially under the current tax system. So far in 2017, the Russel 2000 has underperformed the S&P by almost 7 percentage points. Because of this underperformance, the 5-year performance record for small caps has now fallen below the performance record for larger companies. Investors who have chosen to take a chance on investing in smaller companies are essentially facing financial consequences because the current tax system is structured in favor of larger and wealthier businesses.
Kevin E. Thorn, the managing partner of Thorn Law Group, is recognized as a leader in his area of practice throughout the country and across the globe. His clients are individuals, tax professional...
