Earnings boost from tax reform may not be so hot after all

Finally, tax reform is at least coming up on President Donald Trump's agenda.

He hosted a meeting on tax reform and trade with the ranking members of the Congressional Finance and Ways and Means Committee, which included Senator Orrin Hatch. There's hope investors may soon get a better sense of the timetable for reform.

House Speaker Paul Ryan said that lawmakers will try to push through tax reform and infrastructure bills in the spring after focusing on healthcare.

However, traders are being made aware that initial euphoria over tax cuts may have been a bit too, well, euphoric.

Bank of America/Merrill Lynch's equity and quantitative strategist, Savita Subramanian, has released a very comprehensive review of tax reform, as part of a 25-page walk-through of several scenarios.

Two assumptions inform Subramanian's analysis:

1. Tax reform is a 2018 event, implying there will be no impact on 2017 earnings.
2. Much of the analysis is based on the tax reform proposal embodied in House Speaker Paul Ryan's Blueprint proposal.

The actual impact of a straight tax cut on earnings depends on the details, specifically on whether the tax rate moves from 35 percent to 15, 20, or 25 percent.

Let's work with a 20 percent rate. Subramanian assumes the U.S. would move to a territorial tax system that would no longer tax foreign profits.

Here's the good news: Subramanian estimates that cutting the corporate tax rate to 20 percent would add $17 to S&P 500 Index earnings in 2018—a boost of roughly 12 percent to the current $137 estimate. However, she assumes companies would be able to retain only half of the benefit ($8) because the rest would be passed on to customers, or competed away. That $8 boost is right in the middle of other estimates I have seen, and would certainly be a healthy boost.

Now the bad news: Subramanian goes further, since Ryan's plan also proposes to:

1. End the ability to deduct debt interest, which she estimates would reduce earnings by $0.50 to $1.50 initially, but more over time;
2. Implement a border adjustment tax: While Trump has said such a tax is "too complicated" it would reduce earnings $5-$6 (about 4 percent), though Subramanian admits there is a "complex interplay" with foreign exchange rates and other factors;
3. Impose a mandatory tax of overseas earnings at reduced rates. Subramanian believes non-financials in the S&P hold at least $1.2 trillion in overseas cash, and assumes half would be used for buybacks, which would result in a share count reduction that would add $4 (3 percent) to earnings.

A $5.00-$6.00 boost (about 4 percent) is nothing to sneeze at, but it's certainly a bit shy of what many on Wall Street are expecting. You can see why the border adjustment tax is so unpopular with the financial community.

The results are actually worse, Subramanian notes, when the long-term effect of ending interest rate deductions is factored in. Instead of reducing earnings 50 cents to $1.50 initially, the long-term impact would cost $5.00 in earnings.

This greatly reduces the positive impact on earnings. Instead of a $5.00-$6.00 positive impact, the gain is now a mere $1.50.

Bottom line: A much more nuanced analysis of tax reform is now emerging. When the positive impact of a tax rate reduction and a share count reduction from buybacks is considered alongside the negative impact of ending interest rate deductions and a border adjustment tax, the impact on earnings is far less of a boost.

All this could change, of course. Senate Republicans have already express discomfort over the border adjustment tax plan.

Regardless: This is what I mean when I said Tuesday that the markets may be settling into a period of more realistic expectations when it comes to big earnings boosts from tax reform.