What s your tax reform IQ? Top 10 takeaways

What s your tax reform IQ? Top 10 takeaways On December 22, 2017, President Trump signed into law the highly anticipated tax bill, and most provisions became effective on January 1, 2018. For the first time in over 30 years, we are faced with an overhauled U.S. tax code and revised regulations that have made it even more massive and labyrinthine. In our continuing effort to keep you abreast of the new law s most significant potential effects on taxpayers, markets, and the economy while never substituting for tax advice we thought it would be fun to provide a quiz that tests your knowledge. See how many questions you get right a perfect score puts you at the head of the class! 1. How does the Tax Cuts and Jobs Act (the Act) stack up against historical tax legislation (measured as percentage of gross domestic product, or GDP, averaged over the first two years)? a. Largest in history b. Second-largest to the 1981 tax cuts c. Slightly below the 2001 tax cuts d. Insignificant compared to prior tax legislation 2. How much do we expect the Act to add to GDP growth in 2018? a. 0% b. 0%.25% c. 0.25%.5% d. 0.5%.75% e. >1% 3. The Joint Committee on Taxation (JCT) estimates the largest tax savings in 2018 as a percent of federal taxes paid will go to: a. Those making $20,000 $30,000 b. Those making $50,000 $75,000 c. Those making $100,000 $200,000 d. Those making $1,000,000 and over 2018 Wilmington Trust Corporation and its affiliates. All rights reserved. page 1

4. Corporations are likely to do the following with their tax savings: a. Raise wages b. Invest in plants, machinery, and technology c. Buy back stocks or pay out dividends d. Compete on price e. All of the above 5. The sector to receive the least benefit from the reduction in the corporate income tax rate alone will be: a. Technology b. Healthcare c. Financials d. Consumer discretionary e. Energy 6. Our view is that repatriating overseas profits will have what effect on the U.S. dollar (USD)? a. Weaken the dollar b. Strengthen the dollar c. Mixed 7. What effect is the tax bill likely to have on the municipal bond market? a. Supportive for prices, as it is likely to reduce supply b. Negative for prices, as it is likely to increase supply c. Negative for prices, as it is likely to reduce demand d. Supportive for prices, as it is likely to increase demand 8. How is tax reform likely to impact the taxable high-yield bond market? a. No effect b. Positive effect, as it will force issuers to shore up their balance sheets c. Negative effect, as it will put strain on lower-rated issuers d. Mixed, as lower rates would be partially offset by the loss of interest deductibility 2018 Wilmington Trust Corporation and its affiliates. All rights reserved. page 2

9. The reduced mortgage interest deduction, in our view, will: a. Help the housing market b. Have a muted impact on the housing market, with more pronounced impacts in certain regions c. Cause a broad-based decline in home prices 10. What is one of the most underappreciated risks associated with the tax reform package? a. Trade war b. Consumers and businesses neglect to spend their tax savings c. The Fed hikes aggressively in the face of higher inflation d. A more muted long-term growth outlook in light of higher debt and deficit levels a n s w e r k e y 1. b The Act will cut taxes for corporations and individuals by about $200 billion in 2018, equal to about 1% of GDP. That puts this piece of legislation second only to the Economic Recovery Tax Act of 1981 in terms of the tax revenue impact. Importantly, this is not to say that we expect U.S. economic growth to increase by 1% as the true economic impact of the legislation will depend upon a number of factors, including how much of their tax savings individuals and corporations save versus spend. 2. d Our baseline estimate for 2018 U.S. real GDP growth (excluding any impact from tax cuts) is 2.25% year over year, just outpacing the postrecession average. Once we factor in the impact of tax cuts, we estimate an additional 0.5% 0.75% in growth, bringing our estimate for 2018 real GDP growth to a range of 2.75% 3.0% year over year. We expect the biggest economic impact to come from increased personal consumption, as consumers find themselves with more discretionary income, and more capital spending, and businesses have more cash and greater incentive to invest in plants, machinery, and technology. 3. a Despite some misconceptions regarding the distribution of the Act s cuts, those making $20,000 $30,000 will receive the greatest reduction in federal taxes paid, seeing a savings of 13.5%. This is important because consumers in the bottom of the income distribution have a higher propensity to spend than those in the wealthier income buckets, thereby meaning more of the tax cuts will make their way back into the economy rather than being saved. The Act s estimates for the long-term impact of the tax cuts to individuals of various incomes differ and, in general, favor higher income distributions, due in part to their estimates of the lost Affordable Care Act cost-sharing subsidies. 4. e We expect that corporations will spend their tax savings and repatriated earnings in a number of ways. With the labor market the tightest it has been in over a decade, it is likely that labor competition and wage pressures will require companies to deploy some capital to retain and attract quality workers. Tax savings and greater incentive to invest in capital improvements (through 100% immediate expensing) are likely to lead to a continuation of the capital expenditures boost seen in 2017. Corporations will also almost certainly deploy some capital to buy back stock or increase shareholder dividends. One of the less appreciated destinations of tax savings could be price competition. In the wake of the Act s passage, we are already hearing a number of retailers and other companies discuss investment in price to compete for market share, which would contribute to downward pressure on price inflation. 2018 Wilmington Trust Corporation and its affiliates. All rights reserved. page 3

5. a Technology has the lowest effective tax rate of any sector in the S&P 500, at about 23%, compared to roughly 27% for the overall S&P 500. A drop in the corporate tax rate from 35% to 21% will therefore be much less of a boost to the after-tax income of the technology sector than consumer discretionary, for example (which has an effective tax rate of 31%). However, we retain a positive outlook for technology, as the sector also stands to benefit from repatriation and a potential pickup in technology-related capital expenditures. 6. c In our view, the outlook for the USD is mixed as a result of tax reform. On the one hand, higher growth that leads to inflation and a more aggressive Federal Reserve would be supportive of a stronger USD. Repatriation of overseas profits is also dollar positive. However, some estimates are that nearly half of overseas earnings are already denominated in USD, greatly muting the impact of USD being brought home. Long term, a higher U.S. debt burden from the cost of the tax plan could put downward pressure on the USD. 7. a One of the less-discussed details of the tax plan is the elimination of the tax-exempt quality of advance refunding municipal bonds, or bonds that are issued by a municipality usually at a lower rate in order to pay off an already-outstanding bond. We estimate advance refunding bonds constituted around 15% of the municipal bond market in 2017, thereby putting a significant dent in estimated supply for 2018. Also impacting supply was the threat from earlier versions of the tax bill to eliminate private activity bonds (PABs), e.g., higher education and hospital revenue bonds, which pushed up many issues from 1Q2018 to 4Q2017, ahead of tax reform. This rush to market resulted in December s all-time monthly record of new issuance of $66B that was borrowed from 2018 supply. On the demand side, while the dramatic decline in tax rates for corporations may impact their appetite for buying municipal bonds, they represent a relatively small percentage of buyers. Individuals, on the other hand, dominate the ownership of municipal bonds and will experience only a minimal change in tax rates. Overall demand should be relatively unaffected by the tax changes. We expect the combined supply and demand dynamics to support prices for municipal bonds. (For more on this, see the 4Q17 Municipal Bond Commentary.) 8. d Our outlook on the taxable high-yield bond market is mixed in light of tax reform. The Act limits the deductibility of corporate interest to 30% of earnings before interest, tax, depreciation, and amortization (EBITDA) for the next four years and 30% of EBIT (a less generous deduction) thereafter. This could strain high-yield debt issuers over the long term, particularly those in the lowest credit buckets, who typically rely heavily on their interest deduction as a means of managing balance sheets, in turn leading to an increase in defaults and a widening of high-yield interest rate spreads for this credit segment. However, non-investment-grade borrowers that do not exceed the 30% cap could see higher profitability from lower tax rates and stronger economic growth. 9. b The reduced limit of $750,000 for deducting mortgage interest is temporary (reverts to $1 million after 2025) and impacts less than 5% of the U.S. housing market. Regional impacts, however, could be more significant. As an example, in 3Q2017, about 19% of new homes sold in the Northeast cost $750,000 or more. However, changes to the standard deduction and state and local tax deductions will likely see the number of taxpayers who itemize now about 30% of filers reduced by 75%, according to the Tax Policy Center. This could have an impact on the after-tax return potential of owning a home. 10. d There are always risks associated with market and economic forecasts. In our view, while there is a risk that the Fed moves quicker than the market expects, we expect the Fed to be more biased to letting inflation overshoot its target, rather than risk getting ahead of what have been only tepid inflationary pressures this past year. However, the cost of the tax package is concerning. While macroeconomic feedback effects are very difficult to accurately estimate, the $1.5 trillion price tag on the Act is unlikely to be completely offset by growth. The Congressional Budget Office already expects the federal debt held by the public to increase from 75% of GDP to 150% by 2050. Adding the JCT s analysis of the cost of the tax legislation would exacerbate this even further risking long-term private growth being crowded out by the debt burden. Meghan Shue, Senior Investment Strategist 2018 Wilmington Trust Corporation and its affiliates. All rights reserved. page 4

Disclosures Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Wilmington Trust Company, operating in Delaware only, Wilmington Trust, N.A., M&T Bank, and certain other affiliates provide various fiduciary and non-fiduciary services, including trustee, custodial, agency, investment management and other services. Wilmington Trust Investment Advisors, Inc., a subsidiary of M&T Bank, is a SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T affiliates and clients. Brokerage services, mutual funds services and other securities are offered by M&T Securities, Inc., a registered broker/dealer, wholly owned subsidiary of M&T Bank, and member of the FINRA and SIPC. Wilmington Funds are entities separate and apart from Wilmington Trust, M&T Bank, and M&T Securities. These materials are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports. The information in this commentary has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor s objectives, financial situation, and particular needs. The investments or investment strategies discussed herein may not be suitable for every investor. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed. Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Any positioning information provided does not include all positions that were taken in client accounts and may not be representative of current positioning. It should not be assumed that the positions described are or will be profitable or that positions taken in the future will be profitable or will equal the performance of those described. Indexes are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs that would reduce returns. Past performance is no guarantee of future results. Investing involves risk and you may incur a profit or a loss. All investments carry some degree of risk. Return volatility, as measured by standard deviation, of asset classes is often used as a proxy for illustrating risk. Volatility serves as a collective, quantitative estimate of risks present to varying degrees in the respective asset classes (e.g., liquidity, credit, and default risks). Certain types of risk may be underrepresented by this measure. Investors should develop a thorough understanding of the risks of any investment prior to committing funds. Quality ratings are used to evaluate the likelihood of default by a bond issuer. Independent rating agencies, such as Moody s Investors Service and Standard & Poors, analyze the financial strength of each bond s issuer. Ratings range from Aaa or AAA (highest quality) to C or D (lowest quality). Bonds rated Baa3 or BBB and better are considered Investment Grade. Bonds rated Ba1 or BB and below are Speculative Grade (also High Yield. ) Limitations on use: This publication is intended to provide general information only and is not intended to provide specific investment, legal, tax, or accounting advice for any individual. Although information contained herein was prepared from sources believed to be reliable, Wilmington Trust does not make any representations concerning the completeness or accuracy of such information. Opinions are subject to change without notice. Before acting on any information included in this publication you should consult with your professional advisor or attorney. Third-party trademarks and brands are the property of their respective owners. 2018 Wilmington Trust Corporation and its affiliates. All rights reserved. CS17672 3/2018 page 5