Up and Down Wall Street
The GOP Rethinks Debt and Taxes
The GOP tax proposal cuts corporate taxes and eliminates key individual deductions. But we’re a long way from a final bill.
By Randall W. Forsyth
.
KAREN BLEIER/AFP/Getty Images
The tax bill introduced last week by Republicans in the House of Representatives has plenty of cuts in rates, but fewer reforms. As for simplification, a 429-page document hardly qualifies as simple. And far from putting tax preparers out of business, the proposal will keep lobbyists and tax lawyers extra busy, as the House attempts mightily to meet the Thanksgiving deadline imposed by President Donald Trump to produce a bill to send to the Senate. The World’s Greatest Deliberative Body—at least in the opinion of a select group of 100 men and women—is then supposed to pass tax legislation by Christmas.
Even if such a miracle does come to pass, there are certain to be lots of changes in the legislation by the time the stockings are hung by the chimney with care. The proposals at this point, as John Kimelman and Karen Hube outline, concern mainly a reduction in the corporate tax rate, to 20% from the current statutory 35%, plus a lowering of personal tax rates, which are paid for by the elimination of—or reductions in—various deductions and other breaks.
Prominent among those—and of key importance to investors—are the scuttling or curbing of incentives to borrow that are buried deep into the tax code. Perhaps most noticed is the halving of the size of home mortgages that qualify for interest deductibility, to $500,000 from $1 million. Under the new ceiling, the most expensive house that would get full deductibility would go for $625,000, assuming a 20% down payment and an 80% loan-to-value ratio, the kind of safe and sane loan that once again has become common after the subprime debacle that precipitated the financial crisis. That’s more than the national median, but way below what houses cost in pricey places on the coasts.
Mortgages are the biggest part of the credit market, but at this point, the impact of tax changes is imponderable. The uncertainty of the timing and magnitude of cash flows from mortgages is what makes the sector so difficult, and what attracts so-called rocket scientists in advanced mathematics to model how the loans will get paid off, which depends on whether homeowners decide to refinance or move.
Under the tax proposals, current homeowners are grandfathered in and can continue to deduct interest on mortgages up to the old $1 million cap. Plus they will be allowed to refinance and keep up to a $1 million deductible loan. But the proposed measure would eliminate the mortgage deduction for second homes. Baby boomers would then ask the musical question from the Clash: Should I stay or should I go?
Another big part of the tax plan is the elimination of the federal deduction for state and local taxes, with an exclusion for $10,000 in property taxes. In states with high taxes and high house prices, that’s a massive hit to the upper-middle class. Once the kids are out of school, parents may be even more likely to flee to more salubrious places, in terms of climate, housing costs, and taxes.
All else being equal, that will reduce the size of the mortgage market over time. That is, if the changes come to pass—the real estate lobby will fight them tooth and nail. Nevertheless, a shrinkage of demand from the biggest sector of the credit market ought to exert downward pressure on interest rates.
The bill also would take away incentives for corporations to go into hock. At a lower tax rate, the dollar value of interest deductions falls, so the after-tax cost to borrow would be higher.
Given historically low interest rates and a 20% tax rate, corporations would still have access to really cheap money, which they could tap for share repurchases.
But there are other, more specific disincentives to corporate borrowing. In effect, the proposed legislation would limit net interest deductibility to 30% of earnings before interest, taxes, depreciation, and amortization (Ebitda), Goldman Sachs economist Alec Phillips writes in a client note. Regulated utilities and the real estate sector would be exempt, however.
Among the large companies in the Standard & Poor’s 500 index, few would be affected by such a limit.
According to Morgan Stanley economists, less than 4% with an investment-grade credit rating would bump up against this ceiling. “However, about one-third of the high-yield universe would see interest deductibility capped, and for those levered credits, this change is a headwind, especially with no grandfathering of existing debt,” they write.
In addition, the Morgan Stanley crew continues, when times are tough and Ebitda falls, speculative-grade companies won’t be able to take deductions for interest expense. Think back a couple of years when oil prices crashed and levered energy outfits were caught in a vise of falling revenue and high interest costs. Losing the tax benefit would exacerbate such a squeeze.
Repatriation of foreign profits also will curb borrowing, since companies could bring money home to give to shareholders in dividends and buybacks, rather than issuing bonds, according to Bank of America Merrill Lynch economists. However, they add, that might be offset by increased merger-and-acquisition activity once uncertainties revolving around tax reform are lifted.
Finally, the tax bill would curb borrowing in the municipal-bond market. While the exemption on interest on most types of muni bonds would be retained, so-called private-purpose bonds would lose that privilege.
In particular, bonds to finance sports stadiums no longer would qualify for tax-exempt bond financing, This will mean billionaire owners of sports teams would have to build their stadia with private, taxable money, and that “should keep municipalities from being on the hook for bad stadium deals,” according to John R. Mousseau, director of fixed income at Cumberland Advisors.
Tax-exempt financing for nonprofit hospitals and private universities also would be ended, along with “advance refunding” bonds. The latter provision would hurt municipalities. They’ve saved billions of dollars by reducing borrowing costs with these financings, Mousseau notes. He thinks this provision will be killed, given that it hits municipalities while they cope with pension expenses. On the other hand, Washington needs the bucks to keep the tax bill’s cost under $1.5 trillion, while providing cuts to corporations.
Ultimately, he sees the elimination of deductions for state and local income taxes boosting in-state demand for bonds exempt from those levies. But there also will be pressure to roll back state taxes in high-tax states. At the same time, residents of high-tax states such as New York, New Jersey, Massachusetts, and California will step up their exodus to lower-tax states, such as Nevada, Texas, and Florida, Mousseau concludes. That would erode the tax base of high-tax states and localities, which supports general-obligation muni debt.
In all, the proposed changes could have huge but unknown effects on the American way of borrowing.
During the tax-reform push three decades ago, the saying was that the bill was being written on a word processor, then the state of the art in computing, which allowed continuous revision.
This campaign is just beginning and everything is subject to change.
WHILE THE TAX PACKAGE contained some surprises, President Trump’s nomination of Jerome Powell as Federal Reserve chair to succeed Janet Yellen was exactly what was expected. Ditto the Federal Open Market Committee’s decision to keep short-term interest rates unchanged at its meeting last week, while also indicating that another quarter-point increase is all but certain in December.
Powell is likely to maintain the predictable path set out by his predecessor, which undoubtedly was a major point in his favor for the White House (along with being a Republican, as opposed to Yellen, a Democrat). Assuming she departs from the Fed’s Board when her term as chair ends in February, Trump would have four more seats to fill, giving him the chance to recast the central bank.
No need to rock the boat now, given the stock market’s ending the week at records for the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite. Meanwhile, the economy continues to chug along, with unemployment dropping to 4.1% in October, the lowest level since December 2000.
Things clearly ain’t broken at the Fed, so there’s no need to fix things (other than party affiliation).
That said, the latest jobs report was less stellar than the headlines, notwithstanding a 261,000 jump in nonfarm payrolls. That was short of the 300,000 rise forecast after September’s hurricane-hit tally, which was revised to a gain of 18,000 from a drop of 33,000. But average hourly earnings were unchanged in October, after an aberrant upward blip of 0.5% in September, when low-paid workers couldn’t get to work because of the storms. As for the drop in the headline jobless rate, that mainly reflected a 765,000 plunge in the labor force, bringing the participation rate down sharply to 62.7% of the adult population, from 63.1% in September.
The question before the Powell Fed will be whether the U.S. economy is at full employment and needs significantly higher interest rates. After the expected December rate hike, the fed-funds futures market sees only one more increase in 2018, while the FOMC’s dot plots imply three rises next year. The issue will be whether the labor market or the stock market counts more for the new central bank leadership.
Prominent among those—and of key importance to investors—are the scuttling or curbing of incentives to borrow that are buried deep into the tax code. Perhaps most noticed is the halving of the size of home mortgages that qualify for interest deductibility, to $500,000 from $1 million. Under the new ceiling, the most expensive house that would get full deductibility would go for $625,000, assuming a 20% down payment and an 80% loan-to-value ratio, the kind of safe and sane loan that once again has become common after the subprime debacle that precipitated the financial crisis. That’s more than the national median, but way below what houses cost in pricey places on the coasts.
Mortgages are the biggest part of the credit market, but at this point, the impact of tax changes is imponderable. The uncertainty of the timing and magnitude of cash flows from mortgages is what makes the sector so difficult, and what attracts so-called rocket scientists in advanced mathematics to model how the loans will get paid off, which depends on whether homeowners decide to refinance or move.
Under the tax proposals, current homeowners are grandfathered in and can continue to deduct interest on mortgages up to the old $1 million cap. Plus they will be allowed to refinance and keep up to a $1 million deductible loan. But the proposed measure would eliminate the mortgage deduction for second homes. Baby boomers would then ask the musical question from the Clash: Should I stay or should I go?
Another big part of the tax plan is the elimination of the federal deduction for state and local taxes, with an exclusion for $10,000 in property taxes. In states with high taxes and high house prices, that’s a massive hit to the upper-middle class. Once the kids are out of school, parents may be even more likely to flee to more salubrious places, in terms of climate, housing costs, and taxes.
All else being equal, that will reduce the size of the mortgage market over time. That is, if the changes come to pass—the real estate lobby will fight them tooth and nail. Nevertheless, a shrinkage of demand from the biggest sector of the credit market ought to exert downward pressure on interest rates.
The bill also would take away incentives for corporations to go into hock. At a lower tax rate, the dollar value of interest deductions falls, so the after-tax cost to borrow would be higher.
Given historically low interest rates and a 20% tax rate, corporations would still have access to really cheap money, which they could tap for share repurchases.
But there are other, more specific disincentives to corporate borrowing. In effect, the proposed legislation would limit net interest deductibility to 30% of earnings before interest, taxes, depreciation, and amortization (Ebitda), Goldman Sachs economist Alec Phillips writes in a client note. Regulated utilities and the real estate sector would be exempt, however.
Among the large companies in the Standard & Poor’s 500 index, few would be affected by such a limit.
According to Morgan Stanley economists, less than 4% with an investment-grade credit rating would bump up against this ceiling. “However, about one-third of the high-yield universe would see interest deductibility capped, and for those levered credits, this change is a headwind, especially with no grandfathering of existing debt,” they write.
Repatriation of foreign profits also will curb borrowing, since companies could bring money home to give to shareholders in dividends and buybacks, rather than issuing bonds, according to Bank of America Merrill Lynch economists. However, they add, that might be offset by increased merger-and-acquisition activity once uncertainties revolving around tax reform are lifted.
Finally, the tax bill would curb borrowing in the municipal-bond market. While the exemption on interest on most types of muni bonds would be retained, so-called private-purpose bonds would lose that privilege.
In particular, bonds to finance sports stadiums no longer would qualify for tax-exempt bond financing, This will mean billionaire owners of sports teams would have to build their stadia with private, taxable money, and that “should keep municipalities from being on the hook for bad stadium deals,” according to John R. Mousseau, director of fixed income at Cumberland Advisors.
Tax-exempt financing for nonprofit hospitals and private universities also would be ended, along with “advance refunding” bonds. The latter provision would hurt municipalities. They’ve saved billions of dollars by reducing borrowing costs with these financings, Mousseau notes. He thinks this provision will be killed, given that it hits municipalities while they cope with pension expenses. On the other hand, Washington needs the bucks to keep the tax bill’s cost under $1.5 trillion, while providing cuts to corporations.
Ultimately, he sees the elimination of deductions for state and local income taxes boosting in-state demand for bonds exempt from those levies. But there also will be pressure to roll back state taxes in high-tax states. At the same time, residents of high-tax states such as New York, New Jersey, Massachusetts, and California will step up their exodus to lower-tax states, such as Nevada, Texas, and Florida, Mousseau concludes. That would erode the tax base of high-tax states and localities, which supports general-obligation muni debt.
In all, the proposed changes could have huge but unknown effects on the American way of borrowing.
During the tax-reform push three decades ago, the saying was that the bill was being written on a word processor, then the state of the art in computing, which allowed continuous revision.
This campaign is just beginning and everything is subject to change.
Powell is likely to maintain the predictable path set out by his predecessor, which undoubtedly was a major point in his favor for the White House (along with being a Republican, as opposed to Yellen, a Democrat). Assuming she departs from the Fed’s Board when her term as chair ends in February, Trump would have four more seats to fill, giving him the chance to recast the central bank.
No need to rock the boat now, given the stock market’s ending the week at records for the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite. Meanwhile, the economy continues to chug along, with unemployment dropping to 4.1% in October, the lowest level since December 2000.
Things clearly ain’t broken at the Fed, so there’s no need to fix things (other than party affiliation).
That said, the latest jobs report was less stellar than the headlines, notwithstanding a 261,000 jump in nonfarm payrolls. That was short of the 300,000 rise forecast after September’s hurricane-hit tally, which was revised to a gain of 18,000 from a drop of 33,000. But average hourly earnings were unchanged in October, after an aberrant upward blip of 0.5% in September, when low-paid workers couldn’t get to work because of the storms. As for the drop in the headline jobless rate, that mainly reflected a 765,000 plunge in the labor force, bringing the participation rate down sharply to 62.7% of the adult population, from 63.1% in September.
The question before the Powell Fed will be whether the U.S. economy is at full employment and needs significantly higher interest rates. After the expected December rate hike, the fed-funds futures market sees only one more increase in 2018, while the FOMC’s dot plots imply three rises next year. The issue will be whether the labor market or the stock market counts more for the new central bank leadership.
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