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Market shouldn't get too excited about tax reform — yet

  • Stocks surged on the prospect that Congressional Republicans will approve changes in corporate and individual tax rates.
  • A proposal could be forthcoming in October from Trump administration officials and congressional leaders, but the plan is expected to change before it ultimately is approved by Congress.
  • Corporate tax reform could include "repatriation" of overseas profits and a new territorial tax, while individual tax law would not end the mortgage deduction or deduction for state and local taxes, according to Strategas analyst Daniel Clifton.
Steven Mnuchin, U.S. Treasury secretary, speaks as Gary Cohn, director of the U.S. National Economic Council, left, listens during the White House press briefing in Washington, D.C., U.S., on Wednesday, April 26, 2017.
Andrew Harrer | Bloomberg | Getty Images
Steven Mnuchin, U.S. Treasury secretary, speaks as Gary Cohn, director of the U.S. National Economic Council, left, listens during the White House press briefing in Washington, D.C., U.S., on Wednesday, April 26, 2017.

Stocks took a leap of faith on the prospects of a congressional tax plan, but hurdles remain and a proposal is not likely to be seen before October.

Following a firestorm over President Donald Trump's response to the violent protests in Charlottesville, Virginia, the topic of tax reform percolated to the surface over the weekend and by Tuesday was a big topic of discussion in the markets.

With the president weakened, a number of Wall Street analysts issued reports saying that changes in tax policy would be something congressional Republicans would want to rally behind ahead of the 2018 midterm election.

Stocks surged Tuesday in their best day since April, after a Politico article said the president's top aides and Republican congressional leaders have made significant progress toward tax reform and have "broad consensus" on ways to cut corporate and individual tax rates. Traders said there was also a rumor that tax changes would allow for "repatriation" of corporate profits from overseas and that would fund a plan to rebuild infrastructure.

"Today's action suggests there is some degree of optimism that something's going to get done. It's still going to be difficult," said Jack Ablin, CIO of BMO Private Bank. "Their willingness to get something done has improved. The likelihood is still very low for this year."

Ablin also pointed to comments from Senate Majority Leader Mitch McConnell, who said there would be "zero chance" getting a vote to lift the debt ceiling. A fight over that or the budget could be a hurdle, delaying efforts to get to tax reform. House Speaker Paul Ryan also said it would be a lot easier to get tax reform than health care.

But even though a proposal is coming from Republican leadership, it is not yet before the full Congress, some members of whom might balk at legislation if they do not believe it would be revenue neutral. There also have been signs of a rocky relationship between McConnell and Trump, who criticized the senator on Twitter for not getting health-care legislation approved. On Tuesday, The New York Times reported on how deep the divisions run.

Daniel Clifton, head of policy research at Strategas Research Partners, said he believes there has been progress made towards a tax plan, with more advances made on corporate taxes than on individual taxes. The group working on the tax plan includes leaders from the House and Senate, as well as Treasury Secretary Steven Mnuchin and White House economic adviser Gary Cohn. Cohn had been reportedly disgusted by the president's failure to condemn white supremacists and had been rumored to be leaving after last week's turmoil. The White House denied those rumors.

Clifton also said it's unlikely a tax plan would be presented before October because Congress needs to approve a budget and raise the U.S. debt ceiling before the end of September.

"Mortgage deduction is not going to be included. And the plan does NOT require lifting taxes on individuals to pay for corporate tax cuts. You should not have that impression," wrote Clifton in an email.

Clifton said a lot of details seem to have been worked out, including a tax structure, where companies would pay a new lower tax rate for their profits earned in the U.S. and overseas. The current rate is 35 percent, and analysts have said it could go to about 25 percent.

"The negotiators have reached a broad agreement on the shift to a territorial tax system which includes a minimum tax on intangible income," Clifton wrote. He said he also expects the plan to remove deductions for non-U.S. companies that have operations in the U.S., on such things as interest and rent. "When you add this up you get nearly $1 trillion of corporate offsets."

As it is now, the corporate tax proposal "lowers tax rates and pays for it by removing existing corporate deductions. There are $700 billion of existing deductions and credits in the corporate code that are not even mentioned before you get to interest deduction," Clifton said in the email. There had been talk of eliminating the interest deduction on corporate debt, but Clifton said it would likely be modified to be a fairly minimal reduction in what can be deducted.

"Negotiators have made little progress on the individual side and many of the individual items included are premature. But our base case is that the tax reforms on the table will likely be focused on low and moderate income and less at the high end," Clifton wrote. He said Congress does not have the votes to remove the deduction for individuals for state and local taxes.

"Without that revenue, then it is harder to lower the top income tax rate. We are targeting the top rate falling to 37 percent but we do believe the pass through rate will fall to 25 percent," he said.

Clifton said there is also a proposal to transform 401(k) plans to "Roth" plans where taxes would be paid now instead of when funds are withdrawn in future years. "You pay upfront taxes on your traditional 401k and then you give tax free savings for life. No brainer," he said.

Brian Gardner, public policy analyst at Keefe, Bruyette, and Woods, says getting "Rothification" in the tax legislation would be difficult, but policymakers have been debating it and it's worth watching.

"We think this change faces a big political fight because any change to the way people save for retirement is likely to face stiff opposition not only from the financial industry but at the grassroots level as well. We think changing the tax rules on retirement accounts will be easily demonized and demagogued and we think most lawmakers will want to avoid this controversy," he wrote in a note.

Tom Block, Fundstrat's Washington policy strategist, said he expects there to be a lot of changes before the proposals become law, but he does expect it to be passed by Congress.

"I do think they're going to do taxes. I continue to think the Republicans simply cannot go home in 2018 and run for re-election without having done anything, and they clearly are not going to do health care," Block said.

The talk of tax reform helped the Dow rally 196 points to 21,899, and the S&P 500 jumped 24 points to 2,452, just above the 50-day moving average.

Despite the rally, the idea that Congress will agree to change the tax law was met with skepticism.

"The only reason people are talking about tax reform is because that's where the focus is naturally shifting. I think this [Politico] article just made people think maybe there's a chance, but I think if people understood the political situation, they would understand it doesn't have a chance," said Peter Boockvar, chief market analyst at Lindsey Group.

Tech stocks, seen as big beneficiaries of repatriation, led the rally, with the Nasdaq up 1.4 percent. The small-cap Russell 2000, an early winner in the post-election Trump trade, was up more than 1.1 percent after reaching the point Monday where it was actually negative on the year. Small-caps typically pay a higher tax rate and could be big winners in a corporate tax overhaul.

The so-called "Trump trade" faded after several months, as the prospects for Trump's pro-growth agenda looked dimmer during the congressional battle to push through a new health-care bill. Those efforts failed, and Congress is seemingly moving on to taxes.

The focus on tax reform could be good for the market, and Ablin said there is not much expectation for it priced in.

"I guess it piqued investors' interest, but it would seem there's still a high degree of skepticism baked into current prices," said Ablin. He also said it may be an effort "to try to move past this embarrassment, to try to change the narrative … and hope that Trump stays on script."