Trump Takes on US Tax System. What Does It Mean for Investors?

After several months of buildup, the Trump administration’s framework for sweeping tax reform was finally unveiled on September 27. To better understand the potential implications for investors, three investment professionals from across Natixis Investment Managers offer insight on various issues – tax drag on portfolios, a recent surge in US stocks, especially small-caps, and reform scenarios.

Our Panel Responses

Curt Overway
Curt Overway, CFA®

President & Portfolio Manager - Managed Portfolio Advisors® President - Active Index Advisors®

What does the tax reform proposal mean for investors’ portfolios? At this point it is hard to say, but a few observations can be made.

First, it is important to point out that this is an initial proposal. While there has been an effort to make this process somewhat more inclusive than other recent failed legislative efforts, this proposal, in its current form, faces significant hurdles. There has already been strong pushback on the elimination of the state and local tax deduction, which is going to make it even harder to put together a package with a palatable impact on the deficit. Much of the hard work has been left to Congress to hash out, so there remains a lot of uncertainty about what any tax reform package might ultimately look like and whether that can get through Congress.

Changes to the individual tax code
One of the key features of the proposal is the collapsing of seven tax brackets into just three with rates of 12%, 25% and 35%. This would lower the tax rate for top income earners from the current rate of 39.6% to 35%, though the framework does provide for the option to add a fourth bracket for high income earners. If this change goes into effect, investors in the top bracket would see taxes on short-term capital gains, interest income and non-qualified dividends drop slightly. There was no specific mention of capital gains or qualified dividend tax rates in the initial framework, so at this point we are assuming those would not change, though they could. With the reduced 35% tax rate, there would likely be a very modest impact on most investment portfolios.

Little change to portfolios
Index-oriented equity portfolios, where the vast majority of the taxable events occurring tend to be long-term capital gains and qualified dividends, wouldn’t probably see much of a change on the after-tax returns realized by investors.

Actively managed equity portfolios typically have higher levels of turnover, which is more likely to create at least some short-term capital gains within those types of portfolios. As a result, one might expect to see a bit more of a positive impact for investors in terms of slightly reduced tax drag on these investments. Analysis we’ve conducted, however, applying the new rates retroactively to broadly diversified actively managed equity portfolios over recent history, suggests this impact will likely be minimal. Our analysis found that applying the lower tax rate of 35% instead of 39.6% for the ordinary income rate had virtually no impact on the after-tax returns of these portfolios.

The muted impact of these changes to the tax code on after-tax investment returns is due to the fact that (1) the changes to rates are relatively modest and (2) much of the returns in equity portfolios are generated through (primarily long-term) capital appreciation and qualified dividend income. At this point there is no discussion about changes to the capital gains or qualified dividend tax rates so these components of return aren’t really impacted.

Investments that generate more of their return through interest income, such as taxable bond portfolios, could have a larger portion of the return subject to lower rates, but with interest rates at very low levels that effect is likely going to be minimal as well.

Elimination of most deductions
The framework also eliminates most deductions, leaving just mortgage interest and charitable contributions. Currently, some investors may be able to deduct certain investment management fees if they itemize deductions. The ability to do this would go away under the proposed framework. This is unlikely to have a big impact for most investors as these fees could only be deducted to the extent that those deductions, along with other miscellaneous deductions, exceeded 2% of adjusted gross income (AGI). For now, the framework provides for retirement savings to remain tax deferred, but this is one issue still on the table.

Under the proposed framework the deduction of state and local taxes would also no longer be allowed. This could mean that the effective marginal tax rates for certain taxpayers in states with high tax rates could end up increasing.

What’s the bottom line?
Tax rates are still going to be at levels that create a meaningful drag on investment returns, often greater than the impact of fees. While there is the potential for this tax drag to decrease slightly, it isn’t likely to have a material effect. It will still remain important for investors and their financial advisors to think about the tax implications of their investment decisions and there will still be a substantial benefit to employing investment strategies and techniques that can help mitigate tax liability.
Curt Overway, CFA®, is a President & Portfolio Manager - Managed Portfolio Advisors® at President - Active Index Advisors®.

Curt Overway is President and Portfolio Manager with Managed Portfolio Advisors® a division of Natixis Advisors, L.P. Based in San Francisco, California, Managed Portfolio Advisors® offers overlay management, product development and portfolio construction capabilities. Mr. Overway is also the president of Active Index Advisors®, another division of Natixis Advisors, L.P. also based in San Francisco, California, which specializes in managing index-based separate account solutions.

Prior to joining Natixis, Mr. Overway was a vice president and principal at Jurika & Voyles, an investment management firm. Previously, he worked as a financial analyst in the Municipal and Corporate Financing group at USL Capital. Mr. Overway has more than 20 years of investment management experience. He received a BS degree in industrial and operations engineering from the University of Michigan and an MBA from the Haas School of Business at the University of California, Berkeley. He also earned an MS degree in development finance from the University of London. Additionally, he has served as an officer in the U.S. Navy. Mr. Overway is a CFA® charterholder and is a member of the CFA Society of San Francisco.

Mr. Overway was selected for Separate Accounts Player of the Year for 2006 by the Institutional Investor News Publishing Group, based particularly on his work with multiple discipline products. He was also nominated for the same honor in 2004.

David Lafferty
David Lafferty, CFA®

Senior Vice President and Chief Market Strategist Natixis Investment Managers — US Distribution

Since the election of President Trump in November last year, markets have had an on-again off-again love affair with the prospects for comprehensive tax reform. With both houses of Congress and the executive branch in Republican hands, the stock market, US interest rates, and the US dollar rose dramatically from election day through February. However, as dysfunction emerged within the GOP on everything from healthcare to immigration policy, interest rates fell back and the US dollar weakened.

Through it all, global equity markets have managed to grind higher on stronger economic data. Then, in late September, Republicans released their much-awaited “framework” for tax reform, collapsing individual tax brackets and dramatically reducing corporate rates – much of it paid for by reducing or eliminating specific tax deductions. This gave markets yet another shot in the arm, reminiscent of those first post-election days in November.

$1 trillion deficit hurdle
We believe markets are somewhat naive about what can be accomplished on the tax front. Global investors have largely misunderstood the “Republican Sweep” in Washington to mean that legislative gridlock has been vanquished. Deep divisions within the GOP call into question what can be accomplished as multiple factions within the party squabble over the details. While core Republicans within the leadership push for lower tax rates, they will be met with intense opposition from a growing caucus of fiscal hawks who are unlikely to sign off on the resulting larger deficits – currently forecast at an additional $1 trillion over 10 years. Even this math is optimistic, given it assumes another trillion in revenue from eliminating the “SALT” deduction for state and local taxes paid. This is likely to be a non-starter for the 20+ Republican legislators from high-tax states like CA, NY, and NJ. With only a slim margin in the Senate – and zero help from Democrats – any meaningful tax reform must have almost unanimous appeal across these GOP factions. The current framework, while just a starting point for negotiations, hardly meets this standard. For now, the tax math is devoid of political reality: You cannot simultaneously lower rates, hold the line on deficits, and preserve cherished tax breaks.

Three scenarios for tax reform
At this point, we handicap three possible scenarios: One, a complete breakdown of tax reform resulting in no meaningful change in legislation – à la “repeal & replace” (45%). Two, minimal tax reform in 2018 with only modest reductions in rates (both individual and corporate) and few revenue offsets (45%). And three, a damn-the-torpedoes deficit-swelling tax cut where fiscal hawks acquiesce for fear of being seen as obstructionist going into the mid-term elections (10%). Given my estimate on the likelihood of these scenarios, equity investors would be wise to base their optimism on the slowly strengthening global economy, rather than the hope of meaningful Keynesian tax stimulus.
David Lafferty, CFA®, is a Senior Vice President and Chief Market Strategist at Natixis Investment Managers — US Distribution.

David Lafferty is Senior Vice President and Chief Market Strategist at Natixis Investment Managers. He is responsible for assessing economic and capital market trends and their implications for investment portfolios. His team also works with affiliated asset managers to develop portfolio insights. He has been with Natixis since 2004. Previously, Mr. Lafferty was senior vice president responsible for fixed-income and asset allocation products at State Street Research & Management, developing investment strategies for institutional clients with assets ranging from $10 million to $2 billion. From 1998 to 2001, he was a senior investment strategist at MetLife, structuring asset allocation programs for institutional clients with assets totaling $600 million. From 2008 to 2012, he served on the Board of Directors of Caspian Capital Management/Caspian Private Equity, a New York based hedge fund and private equity firm.

Mr. Lafferty is a frequent speaker at industry events and is often quoted in Barron’s, Bloomberg, The Wall Street Journal and other financial publications. He received his BA from the University of New Hampshire and his MSF (Master of Science in Finance) from Suffolk University. He is a member of the Boston Security Analyst Society, the CFA Institute, and the National Association for Business Economics (NABE) and has more than 20 years of investment industry experience.

Chris D. Wallis
Chris D. Wallis, CFA®

CEO, CIO and Senior Portfolio Manager — Equity Investments Vaughan Nelson Investment Management

In anticipation of the Trump administration’s tax reform plans, a strong rally took place in the US small-cap equity market in Q3, as measured by the Russell 2000 Index. I would caution that there appears to be a false narrative in the market.

I think many investors seem to believe that any tax reform will have a disproportionate positive effect on US small-cap stocks. This belief could be misguided for a few reasons. First of all, a notable percentage of stocks in the Russell 2000 Index will be unaffected by any reduction in tax rates.

  • Approximately 30% of the companies in the Russell 2000 are currently not making money. They are not posting positive earnings. So tax wise, a lower percentage of zero should not make any difference.
  • Roughly 12% of the Russell 2000 is comprised of real estate investment trusts (REITs) and utilities. REITS are considered pass-through entities and therefore do not pay taxes.
  • Utilities, especially those that are regulated, already utilize tax incentives under the current code, leaving little room for improvement.
Then, if and when tax cuts are implemented a loss of interest rate deductions would make the cost of capital more expensive. This could lower the price-to-earnings ratio on many small-cap stocks, which may also lessen the attractiveness of a small company when looking to be acquired.

Mixed emotions for large companies
Regarding the US large-cap space, I think the effect of the tax reform would be mixed as the overall tax rate on cash could be higher for some companies.

The proposed tax reform is looking to incentivize companies to repatriate overseas earnings. But the direct impact on the US dollar’s exchange rate would probably be minimal. This is because a lot of cash held by American businesses’ foreign subsidiaries is already held in US dollars. So overall, I don’t think repatriation matters on the margin.

In this type of environment, I believe an active manager can add value by sifting through the market and in an effort to avoid stocks that could suffer once liquidity becomes constrained, or interest rates move higher.
Chris D. Wallis, CFA®, is a CEO, CIO and Senior Portfolio Manager — Equity Investments at Vaughan Nelson Investment Management.

Chris Wallis is Chief Executive Officer, Chief Investment Officer and Senior Portfolio Manager – Equity Investments at Vaughan Nelson Investment Management. He serves on the portfolio management team of two Vaughan Nelson Funds and as a member of the firm’s Management Committee.

Mr. Wallis joined the firm in 1999 and was previously employed by Simmons & Company International and Coopers & Lybrand, L.L.P. He has 22 years of investment management / financial analysis and accounting experience.

Mr. Wallis received a BBA from Baylor University and an MBA from Harvard Business School. Mr. Wallis is a CFA® charterholder and a member of the CFA Society of Houston.

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