|As Republicans wrestle with conferencing the Tax Cuts and Jobs Act of 2017 to the ground, we reflect on a core constituency of GOP tax policy: the business community. American business is anything but a monolith, making it difficult for Republicans to walk a tightrope and keep the many facets of commerce happy.
A drill-down on how the tax bill drafting was done and the implications for the major facets, below.
The small business lobby has actively influenced the Republican tax writing process. Of particular concern to small businesses are proposed changes to pass through taxation. Changes in passthrough provisions will have a substantial impact on the lives of Americans — 95 percent of American businesses are registered as passthroughs, although most passthrough income goes to the top one percent of earners.
House: The National Federation of Independent Businesses (NFIB) slammed the first version of the House bill released early last month. The House version dropped the pass through tax rate to 25 percent, but subjected this income to the “70/30 rule,” which would only allow 30 percent of pass through income to qualify for the lowered rate (the remaining 70 percent would be subject to top marginal individual tax rate). In the face of pressure, Ways and Means Chair Kevin Brady backpedalled and introduced an amendment that would phase in a nine percent rate for businesses that earn less than $75,000, eventually winning the NFIB’s support.
Senate — Passthrough taxation was no less dramatic in the Senate where Ron Johnson (R-WI) became the first Republican holdout on the bill, claiming it unfairly benefited large corporations at the expense of small business. Sen. Daines (R-MT) soon joined Sen. Johnson in opposition on the grounds that small business was inadequately helped by the Senate version of the bill. The two Senators were able to extract significant concessions for small businesses, increasing the passthrough tax deduction from 17 to 23 percent.
While both bills are a win for passthrough entities, small business groups are especially pleased with efforts in the Senate. After the 70/30 rule is applied, the effective passthrough rate under the House bill would be 35.2 percent compared to the Senate bill’s 29.6 percent. Earlier this week NFIB President Janita Duggan issued a statement detailing the organization’s support of the bill, urging “House and Senate to reconcile their respective plans quickly so the President can sign tax reform into law this year.” Expect lawmakers to come down closer to the Senate’s approach to pass through taxation.
Sectoral Winners and Losers
As advertised, the big winners of the Republican tax sweepstakes are American corporations of all stripes. Some corporations, however, win more bigly than others. From the onset, tax reform has been bound up with Republican culture war issues. While this has mostly played out on the individual side with the battle over state and local taxes in blue states like New York and California and teachers and students losing out at the expense of the wealthy, corporate favoritism also made it through the Senate.
Multinationals — Large, multinational firms have a lot to like in a Republican tax bill that would lower the corporate tax rate to 20 percent and shift the United States to a territorial tax system. How much any individual firm likes the bill, however, will vary depending on its size and structure. Some in the small business community are concerned that these potential gains for large multinationals will come at the expense of smaller domestic firms.
Tech — Leaders in the tech industry, home of some of the country’s largest multinationals, has periodically sparred with Trump over the President’s turbulent first year in office. This prompted speculation that the tax bill might be structured to the disadvantage of tech firms, but this does not seem to be the case. The one time repatriation rate of 14.5 percent for cash returns and 7.5 percent for non-cash returns in the Senate bill would save the largest technology firms billions. These benefits could be offset by the last-minute retention of the corporate Alternative Minimum Tax (AMT) in the Senate bill. The AMT would be a gut punch to firms like Apple, Microsoft, and Citco with substantial research costs because such a tax would effectively eliminate the R&D tax credit.
Energy — Keeping the corporate AMT was also a surprise to coal companies. Coal executives fear that they will be wiped out by the proposed retention of the AMT. The House version of the bill repeals the tax, and House Majority Leader Kevin McCarthy has already called for the provision to be sent to the chopping block. Look for the conference committee to make substantial changes to the corporate AMT in order to protect one of Trump’s darling industries
Real Estate — Commercial real estate, where President Trump made millions, is uniquely privileged in the Republican tax bill. While most industries were asked to sacrifice industry-specific deductions and depreciation allowances in exchange for the lower tax rate, real estate retained most of these special privileges. In fact, real estate ended up getting an even a more generous depreciation timetable than under current law, and now rental and mortgage-interest income can qualify for a lower tax rate previously designated for long-term capital gains.
Telecom — Firms like AT&T which make most of their profits from sales in the United States and would benefit handsomely from the corporate tax rate reduction. In the short term, they would also benefit from a provision that allows companies to immediately expense new equipment purchases for five years. The provision then phases out by 20 percentage points a year thereafter, a delayed sunset introduced to win over holdout Sen. Jeff Flake (R-AZ).
Special Interest Grab-Bag — In the Republican mad dash to get the tax bill over the finish line, a number of targeted special interest provisions were included to win the favor of skeptical Senators. Cruise lines, craft beer and wine producers, car dealers, and pipeline management companies all came away with prizes for being the pet industries of various members.
Corporate Finance: What to do With A Windfall
One of the most common refrains coming from Republicans trying to sell their tax plan is that huge corporate tax cuts are necessary to incentivize businesses to invest in capital expenditure and job creation. A torrent of new jobs is unlikely, and the argument flies in the face of what businesses themselves say.
A Bank of America survey of 300 companies found that only 35 percent of companies planned to direct tax cut funds towards expenditures. Most of the rest, including huge companies like Pfizer and Coca-Cola, indicated that they would continue a decades-long trend and direct the windfall towards shareholders.
This economic behavior appears lost on Republican leaders. During a meeting with business leaders last month at the White House, President Trump’s top economic advisor Gary Cohn seemed confused when only a handful of CEOs raised their hands when asked if they planned to use tax cut money to increase capital expenditures.
Cohn’s bewilderment is curious. Studies conducted by the National Bureau of Economic Research (NBER) in 2014 and 2016 found “little evidence that corporate cuts boost economic activity.” Beyond this, American corporations have accumulated record amounts of cash in recent years, at the same time as corporate investment expenditure and wage growth have stalled. Most of the recent corporate gains have flowed to shareholders in the form of dividend payments and stock buybacks, both of which have spiked in recent decades.
Big Banks’ and Managers’ Big Break
The country’s largest banks escaped any significant damage from Republican tax reform efforts, and Senior bank executives wasted little time in praising the bill. Jamie Dimon, CEO of JPMorgan and Chair of the Business Roundtable, dropped long-standing concerns about the national debt in order to support the budget-busting tax bill. Morgan Stanley’s Chief Executive claimed that even a 25 percent corporate tax rate would lift his bank’s earning by as much as 15 percent.
There is good reason for this optimism. Banks stand to be win big from several components of the Republican tax reform efforts:
Lower Taxes, Higher Profits — Large banks bear some of the largest tax burdens in the country, so they have the most the gain from a reduction in the corporate rate. Bank of America’s Chief Executive, Brian Moynihan made this point explicitly, explaining that BofA is “a taxpayer of high order, so we’ll get a benefit because we’re paying a lot of taxes today.” The country’s five largest diversified banks would have saved as much as $11.5 billion in 2016 had the proposed 20 percent rate been in effect last year, the largest amount for any sub-industry tracked by the S&P.
Carried Interest — Both the House and Senate bills address the politically charged topic of carried interest with similar window dressing. Both versions limit a fund manager’s ability to pay a lower capital gains rate to investments held for at least three years, as opposed to the current one year requirement. Most experts contend that an extended holding period will have little practical impact, because it typically takes three years or more years for assets held by private equity to appreciate to the point of being harvested in a capital gains triggering disposition.
Interest Deductibility — Bankers were concerned that legislators might limit interest deductibility, a move that could have upended the banking model because financial firms are so highly leveraged. Both the House and Senate versions of the bill do cap the deductibility of interest at 30 percent of adjusted income. However, this cap only applies to firms that spend more money on interest than they take in, and because most banks take in more interest than they spend on it, they will be able to effectively sidestep the deductibility cap.
|The conference committee meets behind closed doors tomorrow afternoon, and GOP leaders hope to have a the final compromise hammered out by the end of the week. Going forward it will be important to watch Republicans on the conference committee. Public splits on specific provisions could signal more serious divisions on the bill than currently believed.
Should the bill pass the conference committee as expected, it would go to each chamber for final vote. The Senate votes first in order to ensure Byrd Rule compliance, the House to follow likely the day after. With the Senate slated to vote early next week — the last of the 2017 Congressional session —and to have the President sign before Christmas, if not adjournment.