What stocks to invest in
I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.
The Trump plan appears to have two parts:
–reduce the top corporate tax rate from 35% to, say, 20%. For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.
–eliminate foreign tax reduction devices. American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices. They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places. Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.
How this structure works: a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device. The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250. The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name. It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax. Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.
If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens. At a 20% rate, the firm would pay $80 in federal income tax.
The bottom line: while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused. Just as important, it would eliminate the motivation to create offshore profit centers.
As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks. A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.
– What stocks to invest in