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Investors Should Monitor Tax Reform Developments


February 23, 2015
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Investors can benefit significantly from staying up to date on corporate tax reform developments, as existing policy may have a substantial impact on the stocks of different companies, financial expert Scott Cooley wrote in a recent Morningstar article.

This point could be particularly helpful, as discussions involving corporate income tax reform have generated visibility in Congress.

Reform and investing

Cooley, who is the director of policy research for Morningstar, emphasized that if the federal government ends up approving any proposed changes to the corporate tax structure, this development could easily have a major effect on the financial state of companies.

While lawmakers may encounter challenges reaching a consensus on many different issues, the push for corporate tax reform has generated bipartisan support, he noted. Should lawmakers succeed in their efforts to change policy, the broader asset markets will respond far in advance of the approved legislation being enacted.

Obama tax proposal

With this in mind, market participants might benefit from perusing any progress that is made on Pres. Barack Obama’s proposal to tax foreign earnings. In his State of the Union Address, Obama suggested providing a one-time, 14 percent levy on these profits held overseas.

Under current tax law, these companies only need to pay a tax if they opt to bring these financial resources back to the U.S. Given this setup, many firms simply keep their earnings in foreign countries instead of repatriating them back to the world’s largest economy, where they could face a tax rate of up to 35 percent.

As part of this broader plan, Obama would reduce the top corporate tax rate for profits generated in the U.S. to 28 percent.

Complicated policy

While the current tax rate may seem high, Cooley points out that the effective tax rate is significantly lower. Since U.S. companies face such high corporate income taxes – which can reach 40 percent of income after state taxes are included – these firms have responded by lobbying for different tax breaks that reduce their effective rates.

Many of these efforts have succeeded, and as a result, the framework of tax breaks and subsidies has grown very complex, he emphasized. In addition, the situation has left the U.S. with one of the biggest differences between actual corporate taxes brought in and the stated rate. Because of this lopsided situation, companies have even greater motivation to hire lobbyists to advocate for special tax breaks.

Given the intricate nature of this situation, many have advocated creating a simpler tax code. For example, lawmakers could make the current foreign earnings more straightforward by using a “territorial” system, which involves individual nations only taxing companies for the income generated within their borders, according to FoxNews.com.

Simpler approaches

Currently, this approach has garnered the support of both republican lawmakers and most companies, the media outlet reported. However, Cooley emphasizes that implementing more simplistic tax policies can be challenging.

For example, changing the complex system of U.S. corporate tax breaks could have major implications for these firms, he noted. While Wal-Mart generates most of its revenue domestically and harnesses a small number of actions that generate tax advantages, Johnson & Johnson creates a strong portion of its revenue in overseas countries.

While investors might currently look at the cash flow and price-to-earnings ratios of these companies when determining what to buy, they should keep in mind that these hard numbers may depend on a system of complex tax policies that could soon change.

Even though it is impossible to predict what direction tax reform will take, Cooley wagers that lawmakers will put some effort into changing existing policies in the next few years.