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The costs and benefits of tax reform

2017 could be a watershed year from a tax reform perspective. Trump has continuously stated that tax reform is a priority, and there is evidence of widespread support in Congress. Tax reform could be enacted through reconciliation without the risk of being filibustered, suggesting the timing could be imminent. Corporate tax reform could have a significant impact on S&P 500 earnings, corporate behavior and capital markets. Much has been written on the timing, funding and process by which corporate tax reform could be enacted. In this report, we use House Speaker Paul Ryan’s Blueprint proposal as a starting point in quantifying the impact of corporate tax reform on the S&P 500, with some scenario analysis to account for differences included in the final bill (such as Trump’s proposals). Our analysis is focused specifically on the impact of corporate tax reform, however we recognize that there are many other factors that can impact the sensitivity analysis (e.g. changes to household income tax rates, infrastructure spending, etc.).

We estimate that the Blueprint proposal would initially boost S&P 500 EPS by $5-6, assuming the end of interest expense deductions only applies to new debt, or is phased in over time. But the devil is in the details. Over time, the loss of the interest tax shield would be a significant drag on earnings as existing debt is refinanced. Additionally, the corporate tax rate is critical in determining whether or not the tax reform policies end up being accretive to earnings on a sustained basis. We estimate that at the 20% tax rate, the Blueprint would be modestly accretive, the benefit would triple under Trump’s proposed 15% tax rate, but at a higher 25% tax rate that would appease the deficit hawks in Congress, the benefit would turn to a negative over time (Table 2). We also estimate a one-time $8-9 charge to GAAP EPS that would be associated with the discounted repatriation tax.

Table 2: Estimated impact of tax reform on S&P 500 2018 EPS

Tax policy | 15% | 20% | 25%
Tax rate change | 10.50 | 8.00 | 5.00
Ending interest deductibility – initial impact* | -0.50 to -1.00 | -0.50 to -1.50 | -0.50 to -2.00
Border adjustments | -4.00 | -5.50 | -6.50
Share count reduction from buybacks (50%) | 4.00 | 4.00 | 4.00
Total initial impact | 9.50 to 10.00 | 5.00 to 6.00 | 0.50 to 2.00
Ending interest deductibility – recurring impact | -3.50 | -5.00 | -6.00
Recurring impact | 7.00 | 1.50 | -3.50

One-time repatriation tax (8.75%), GAAP charge | -8.50 | -8.50 | -8.50

Source: BofAML US Equity & Quant Strategy, FactSet, Compustat, S&P
*Assumes end to interest deductibility only applies to new debt, where we estimate 70-90% of debt is long-term.
Note: For this exhibit, we assume that 100% of the cash is repatriated and 50% of it is spent on buybacks. For different buyback assumptions, please see the section on repatriation.

In the following pages, we focus on the following topics that have large implications for US equity investors, but it is important to consider corporate tax reform holistically rather than drawing major implications from each measure in isolation:

• Reducing the US corporate tax rate
• Repatriation - mandatory tax on overseas profits
• Border adjustment tax
• Removal of interest expense deduction

The government revenue associated with each of these is included in the table below.

Bank of America Merrill Lynch
Equity Strategy Focus Point | 29 January 2017
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