US tax reform a modest positive for US equities and dollar

The prospective headline cut to the US corporate tax rate from 35% to 20% is a positive but not as significant as it may look at first sight. Historically, the US corporate sector has enjoyed an effective tax rate closer to 25% due to ample scope for deductions. The US Congressional Budget Office believes that the total revenue lost from the US business taxes from the Senate tax bill would be $744bn over 10 years. Following implementation, this would represent approximately a 6% increase in net income for the US corporate sector from 2019.

This is clearly a positive but appears insufficient in our view to push US equities significantly higher from current levels as the magnitude of the effect on both S&P EPS and overall economic growth is relatively modest compared to other factors. Furthermore, the prospective changes have been at least in part discounted by markets over the course of the year. If the proposed changes are shortly signed into law later this month, this will however give markets some comfort that Trump can point to a major legislative success during his administration.

The proposals are also dollar supportive, in addition to signalling that the Trump administration can get things done. First, US tax rates would be much more competitive in an international context thus reducing the incentive for the US corporate sector to invest overseas in preference to the domestic economy. This tax reform is also forecast to increase GDP by between 1-2.7% over a 10-year time horizon.

Second, cash held offshore by the US corporate sector may find its way back into the US, due to a lower one-time rate of 10% on repatriation, compared to an effective rate of close to 40% previously. Although approximately $1tn of cash is held outside the US by the US corporate sector, the actual repatriation amounts are likely to be somewhat less. The majority of this amount is also likely to be already denominated in US dollars, eliminating any direct effect on FX markets.

We also do not view the US corporate sector as capital constrained for domestic investment – if an investment case is supportive a corporate entity may still wish to raise capital domestically rather than pay 10% on existing cash held overseas. Thus while positive for the dollar, the direct effects of this legislation on the US dollar may be more modest compared to the political signalling effect and the direction of US monetary policy during 2018.