By: Lyn Alden
Tax reform is a high priority goal of both Congress and the current administration and a change to the corporate tax rate could impact the TSP C and S Funds, which track American companies. A simple argument for why runs as follows: Tax cuts would increase corporate income, leading to higher stock prices, which in turn would fatten TSP balances. However it’s not that simple and the outlook is less clear because companies don’t actually pay the rate that’s on the books in the first place and the market has already anticipated such cuts.
How might corporate tax cuts affect your TSP account?
The current federal tax rate, at least on paper, is 35% for large companies. And it’s important to note that in this context, “large companies” means any company with at least a few million dollars in annual income. This includes the small-cap S Fund companies as well as the larger C Fund companies.
The Trump administration and the GOP majority in Congress have proposed a 15-20% corporate tax rate, along with possible ways to simplify the tax code and reduce the amount of reductions and loopholes.
Allowing companies to keep 80 cents on the dollar rather than the current 65 cents would represent a 23 percent increase in income. You can bet that if average income among companies in the S Fund and C Fund suddenly rose by 23%, there would be a surge in stock prices, and TSP account balances would swell.
However, tax rates on paper are a far cry from the effective tax rates corporations actually pay.
According to the Government Accountability Office, the average profitable corporation already pays just 14% of their reported income in federal tax, thanks to tax credits, depreciation, and other factors. This figure rises to 22% when you take into account the impact of state and foreign taxes, which Trump and Congress have no significant ability to change. State corporate tax rates range from 0-12%, with most being in the 5-10% range. The figure rises another 10-15% if you include unprofitable companies, since they throw the numbers off in general.
This substantially reduces how much corporations can really save from tax cuts, given that effective federal rates for profitable companies are already pretty low.
Hypothetically, if tax rates were reduced from 35% to 15-20% and all sorts of credits, loopholes, and other complexities were eliminated, some companies could wind up seeing an increase in their effective tax rate, since they pay on average just 14% already.
Given the above, one plausible scenario is that we see a reduction in the statutory tax rate while also keeping in place many of the credits, deductions, and other complexities, merely reducing the effective federal tax rate from the mid-teens down to the low-teens or high single digits. Going from 14% to perhaps 9% wouldn’t have as big of an impact on after-tax income as a statutory change of 35% to 20% might suggest.
If corporations get to effectively keep 91 cents on the dollar compared to 86 cents, that’s less than a 6% increase in after-tax income for profitable corporations, and shouldn’t significantly impact the major market indices that the TSP follows.
Another reason corporate tax cuts might have a more modest impact is that the market has already assumed some form of tax reform and deregulation is in the offing, and that has already been factored into in stock valuations. (Consider the fact that the US stock market has already risen more than 10% since the election.)
At this point, markets have something to lose if tax cuts don’t occur, and not a lot to gain if they do occur, thanks to how highly valued markets already are.
If effective corporate tax rates go down, it would solidify some of the expectations that the market currently has and would reduce the average price-to-earnings ratio of the market a bit thanks to mildly boosted post-tax earnings.
Although healthcare reform recently proved to be elusive, tax reform is probably more likely to occur due to the broad areas of agreement within the GOP on this topic. But the possibility of corporate tax cuts should not really alter a rational investor’s indexed portfolio strategy, such as in the TSP.
This is because in the context of an index fund, the overall amount that the effective corporate tax rates could change is a lot smaller than the size of the tax cuts proposed might suggest.