Market Insider

There are plenty of things that might be in this tax bill that could give the market indigestion

Key Points
  • The much anticipated tax bill, expected to be introduced by the House Wednesday, may include some elements markets will not like.
  • A five-year phase in of the proposed 20 percent corporate tax rate is one.
  • The bill could also include a limit on popular 401K deductions; a limit on the deductions of state and local taxes, and a limit on deductability of corporate interest expenses.
Is tax reform priced into the market?

The much anticipated tax bill should be bullish for stocks, but strategists say some elements of the legislation the House is going to introduce Wednesday could instead give markets pause.

Stocks, already lower on the day, fell further Monday, after a news report said the proposed corporate tax rate of 20 percent would be phased in over five years. While the bill will be far from its anticipated final version, markets could react to any surprises.

"I think that final bill will not be as grand as Donald Trump envisions. It's not going to be as bold. The reason is they're going to phase in aspects of it," said Greg Valliere, chief global strategist with Horizon Investment.

Strategists say there are some big positives expected, like 100 percent deduction of capital expenditures. But the market has been anticipating a big bump in corporate earnings with a 20 percent tax rate that would kick in next year, or even this year. The report about the phase in first appeared from Bloomberg News.

"I think the market doesn't do deep dives when they see news like this," said Peter Boockvar, chief market analyst at Lindsey Group. "What the mentality is here is every Joe Shmoe on Wall Street did their earnings estimates for next year with a 20 percent tax rate."

Stocks recovered some of their initial losses on the report, and the Dow was down about 80 points in afternoon trading after being down more than 100 points. Bond yields also fell on the report, with the 10-year yield touching 2.37. Yields move opposite price.

"If tax reform is phased in, then the economic upside will be phased out," said Ian Lyngen, rate strategist at BMO. "This is the first real week where we're getting down to brass tacks. The first move is to take the teeth out of tax reform."

Here are three things analysts say the market could respond to when the bill in introduced.

  • 401K deduction - There is a proposal to limit this popular deduction that currently allows workers under 50 to save up to $18,000 in this tax retirement account, while older workers can save more. Analysts say this could be perceived as a negative since it would mean less money automatically going into the market with retirement savings.
  • Deduction of interest - There is a proposal to limit the amount of interest a corporation could deduct. This could impact some high debt companies.
  • State and local taxes - This deduction, important in high tax states like New Jeresy, New York and California, is proposed to be dropped. Valliere believes there will be a compromise on it to limit the deduction for high income individuals rather than eliminate it across the board.

Keefe Bruyette and Woods analysts said Wednesday's bill will be a "starting rather than an ending point." They also noted that they do not believe the 20 percent tax rate will hold, and they and other analysts say it will have to move higher as Congress removes deductions.

Analysts say tax writers are struggling to find a way to change the law to allow small businesses to pay the corporate, not individual tax rates, without opening the door for others who might use the bill opportunistically to pay less taxes. "They want to figure out how to stop individuals from gaming the system," said Valliere.

WATCH: Tax reform phase-in talk makes market pull back

Tax reform phase-in talk makes market pull back