Tax Reform and S&P 500 Earnings: What Earnings Recession?

Some S&P 500 companies began booking charges or benefits related to tax reform back in 2017 when the Tax Cuts and Jobs Act (“TCJA”) was enacted, though more of the benefits were recognized in 2018. As a result, 2018 earnings increased by a significant 22.1% over 2017. Because there was such a big jump, 2019 vs. 2018 is a more difficult comparison. The current consensus for 2019 is for about 4.1% earnings growth, followed by +11.2% projected in 2020.

S&P 500 Earnings

YearEarnings per shareGrowth From Previous Year
2017$131.67+11.5%
2018$160.76+22.1%
2019
(Projected)
$167.36+4.1%
2020
(Projected)
$186.13+11.2%

The main impact on companies from the TCJA was to lower the corporate statutory Federal income tax rate from 35% to 21%. The exact effect varies from company to company. This provision of the tax code is permanent, that is, it will remain in effect unless it is changed by future legislation. It is not scheduled to sunset at the end of 2025 as are some individual income tax provisions.

Companies carrying deferred tax assets on their balance sheets initially experience a non-cash charge. On the surface this is somewhat counter-intuitive, the logic is that the value of these assets are now lower because they will only offset taxes at 21% instead of 35% previously. This non-cash charge initially lowers corporate earnings, but then there is the ongoing benefit of a permanent reduction in cash taxes paid each year. This leaves more cash available to hire workers, increase wages and benefits for existing workers, increase dividends, buy back shares or expand operations. In other words, more money will now flow to owners and labor rather than to the government.

We examine the level and trend of corporate effective tax rates as part of our investment due diligence process on individual stocks. For some companies there has not been much change, others have received most or all of the benefits from the 14% rate reduction. Companies have different fiscal years, so the timing of the impact varies from one company to another. The benefit to a particular company also depends on their specific mix of domestic versus international revenue (those with high effective tax rates and revenue that is primarily U.S. benefit the most).

The TCJA also encourages companies with significant cash holdings overseas to return them to the US. The taxes on these assets are at a preferential rate, and companies have the option to spread the tax impact over 8 years or recognize it all at once. This tax is levied on past foreign earnings held overseas regardless of whether the cash is brought back to the U.S. Since companies have to pay the tax anyway, there is now less incentive to leave cash overseas.

The lower corporate tax rate makes U.S. Companies more globally competitive, since under the old system our rate was one of the highest in the world. It also should have the effect of reducing corporate “inversions” whereby a U.S. company moves its headquarters to a foreign country in order to reduce its effective tax rate.

In the short run, these changes are positives for U.S. investors, corporations and workers. Whether these changes will increase or decrease the Federal deficit on an ongoing basis remains to be seen.

Bill Hansen
President and Chief Investment Officer