Well, we have a brand new year, and with it comes much to think about in terms of coming up with a clear-eyed, pragmatic outlook for what we might expect over the next twelve months.
I’m going to discuss two important topics in this article; what we might reasonably expect to see in the financial markets, and how tax reform this year may affect each of us personally.
The big change agents in 2017 are, of course, President-elect Donald Trump and Republican control of both houses of Congress. If we could set aside our own proclivities to view the new leadership with either rose colored glasses or forecasts of impending catastrophe and just look at the fiscal policies that the incoming administration and congressional leaders have discussed, it’s a good bet that corporate income taxes will be coming down pretty dramatically this year. The most likely scenario will be that top federal corporate rates drop from 35% currently, to just 15%.
On the surface, this would imply that corporations will be keeping 20% more net profit, which could support 20% higher stock prices. However, many corporations do not pay anywhere near a 35% tax rate because of aggressive tax reduction strategies they have in place. Michael Thompson, president and chairman of Standard & Poor’s Investment Advisory Services says the effective tax rate for most corporations is closer to 29%, implying perhaps a 14% positive bump in market value just because of these tax cuts. In addition, there is much talk of US companies being incentivized by lower tax rates to repatriate some of the approximately $2 trillion in untaxed profits that are currently sitting in offshore accounts. While this could potentially provide a needed shot in the arm for U.S. economic growth, in the past it has not resulted in significant job growth. Instead, it has been a boon for shareholders through increased dividends and company stock buybacks.
Also this week, a forecast by Deutsche Bank said that U.S. GDP could double by 2018 if Trump’s tax cuts and infrastructure spending are implemented, and if regulations are reduced in a meaningful way.
What could derail that positive outlook? Lots of things, including but not limited to unexpected excesses (i.e. bubbles) being built up in areas of the economy like inflation, wage growth due to extremely low unemployment, or higher interest rates, just to name a few.
There is also the possibility that our inexperienced new president might cause one or more international incidents or even a shooting war as the unintended consequences of his brash outspokenness, which could lead to increased volatility in the markets.
Taking all of this information into account, it does seem reasonable to expect that the wind will be at our back over the next few years in the stock market. This doesn’t mean that we ought to be taking any drastic actions with our investment allocations, however. The world is littered with the carcasses of investors that took on more risk than they could actually handle.
Personal income taxes for each of us will also likely be changing. Our current seven tax brackets, ranging from 10%-39.6% would be consolidated to just three brackets of 12%, 25%, and 33% under the Trump plan. In addition, the Obamacare surtax of 3.8% on investment income is expected to be repealed.
Some House Republicans also have radical tax simplification in mind. They hope to have most Americans filing tax returns on a postcard instead of the often voluminous tax returns we have been used to for most of our lives. These ideas are floated frequently, but it seems unlikely that the special interests in the real estate, insurance in investment industries, just to name a few, would sit by idly while changes of this magnitude decimated their tax-dependent businesses.
Trump’s tax proposals would also consolidate the current personal exemption and standard deduction into one larger standard deduction of $15,000 for a single taxpayer and $30,000 for a married couple. For those who itemize, total itemized deductions would be limited to $100,000 for single filers and $200,000 for marrieds. On the surface this doesn’t seem like a big deal, but for those with large charitable deductions, it could create bigger tax bills.
Trump also proposes an above-the-line deduction for child care expenses, available for up to four children. The deduction would only be available for kids under age 13, and would be capped at the average cost of child care in the state for a child of that age. In addition, the deduction would apply for both third-party child care facilities, and the implied (average) cost of child care would still be deductible if care is provided by stay-at-home parents or (unpaid) relatives serving as caretakers. If enacted, this could provide massive tax reductions for parents with young children.
A similar above-the-line deduction would be available for “elder care” expenses for a dependent parent living in the home. The deduction for eldercare expenses would have a dollar cap of $5,000/year, though. In addition, President-elect Trump has also proposed a new Dependent Care Savings Account (DCSA). Similar to Health Savings Accounts, contributions would be tax-deductible (up to a $2,000/year limit from all sources), and growth would be tax-free.
What are the odds that these tax reforms actually get adopted? It’s a good bet that any package that ultimately gets adopted will be the result of much negotiation between Congress, the president, and the special interests. In addition, we cannot forget that even though Republicans control both houses of the Congress, they do not have a filibuster-proof Senate. If they cannot get a handful of Democratic senators to go along with the ultimate tax plan, it will be impossible to make permanent tax changes.
Instead, the Republicans could aim to pass the legislation under the budget reconciliation rules, which can be accomplished with a simple majority vote. However, under the so-called “Byrd” rule for budget reconciliations, proposals that have a negative impact on revenue beyond 10 years must sunset at the end of that time period, which means if Republicans seek to accomplish tax reform this way, there’s a good chance that it will be scheduled to sunset on December 31st of 2026! (In point of fact, President Bush’s 2001 tax reform legislation also had a sunset provision at the end of 2010, for this exact same reason!)
I hope you find this information useful as you formulate your expectations for the coming year. As always, we are more than happy to discuss these or any other concerns or question you may have, so please give us a call.
Oh, and Happy New Year! One thing is for sure, 2017 will be nothing if not fascinating!