On the morning of his appointment, President-elect Trump’s selection for U.S. Treasury Secretary, Steven Mnuchin, said that tax reform will be a priority of the incoming administration and that the President-elect was still targeting a 15% corporate tax rate. The U.S. statutory Federal corporate income tax is currently among the highest in the world at 35%, while the effective tax rate was only slightly lower in 2015 at 29%. The prioritization of tax reform, inclusive of corporate tax cuts designed to improve the competitive position of U.S. corporations within the global economy, is potentially a huge plus for the equity markets since it can significantly boost earnings growth as early as 2017 and beyond.

Corporate Tax Cuts
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Corporate Tax Cuts

While it is far too early to conduct a comprehensive cost/benefit analysis of tax reform since a detailed proposal is still lacking, the following back-of-the-envelope calculations illustrate the influence that corporate income tax cuts could have on the stock market. S&P 500 index constituent companies are currently expected to earn about $131 per-share in 2017, representing earnings growth of 11.8%, according to S&P Global Market Intelligence consensus earnings data. Accordingly, every one percent reduction in the corporate income tax rate could add back about $1.31 to anticipated 2017 S&P 500 earnings. A five percent reduction in the effective tax rate could hypothetically increase next year’s S&P 500 earnings by $6.55 to $137.54 per share, while a 10% reduction could boost 2017 earnings-per-share to $144.09. The improved calendar year 2017 S&P 500 earnings growth rates would now be 17.4% and 23.0%, respectively, as opposed to the current 11.8% consensus expectations growth rate.

The implications for stock market pricing are potentially dramatic. The S&P 500 index currently trades at a forward price/earnings (P/E) valuation multiple of 17.4x 12-month expected earnings. Placing a 17x P/E on the hypothetical post-corporate tax cut enhanced 2017 S&P 500 earnings numbers produces some eye-popping results. The five percent tax reduction-generated figure of $137.54 implies an underlying (17x) level for the S&P 500 index of about 2,340 (+6%) sometime in the first quarter of 2017, while the inferred 10% tax cut calculated earnings of $144.09 translates to an index price of about 2,450 (+11%).

SPIAS is not suggesting that the stock market is about to immediately experience gains that come anywhere near the admittedly simplistic hypothetical examples just presented, we only mean to illustrate the potential significance that the discussion surrounding corporate tax reform could have on investor psychology and the level of “animal spirits” within the broad economy and financial markets generally. We now await indications of how quickly the details of any forthcoming tax reform proposal can come together and how quickly and efficiently Congress can convert the proposals into legislation.

Article by S&P Global Market Intelligence

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