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:
- End the ability to deduct debt interest, which she estimates would reduce earnings by $0.50 to $1.50 initially, but more over time;
- 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;
- 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.
Estimated impact of tax reform on S&P 500 2018 EPS
Tax rate change $8.00
End interest rate deductibility -$0.50-$1.50
Border adjustment tax -$5.50
Share count reduction from buybacks $4.00
Total initial impact: $5.00-$6.00
Source: Bank of America/Merrill Lynch
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.