There's nothing wrong with Congress's goals for its tax-reform proposal, the Tax Cuts and Jobs Act. The bill seeks to end corporate America's incentive to stash assets overseas; to simplify the tax code; and to reduce the effect that tax policy plays on personal decisions, such as buying a home.
There is no doubt that the tax-reform proposal will reduce home values
My concerns lie not with which taxpayers Congress rewards, but instead with the bill's details. These concerns do not seem to be shared by the lawmakers, who are racing to complete the bill before the holidays. To that end, Congress has bypassed the Treasury department, which customarily runs proposed legislation through a battery of financial tests and pushes back with pointed questions.
Because this bill is complex, the number-crunching that normally amends the kinks hasn't been conducted. The problems outlined below are not insurmountable, given the right approach by policy experts.
The Effect on Stock Market Investing
The Senate proposes to eliminate investors' ability to choose which stocks to sell to minimise their current taxes. Investors would no longer be permitted to identify specific lots; for tax purposes, the first shares in would be the first shares out. In some cases, the rule might stipulate the average price. The “first in, first out” rule means that stocks purchased first, even if an investor is nursing losses on them, will have to be sold – instead of more recent ones where big profits have been made.
To avoid such problems, the savvy investor will game the system by opening separate stock broker accounts, so that he can pick and choose among those accounts when making security sales – the Senate's rule would only apply to shares held with a given broker, not across several firms. This is a law that encourages investors to deconsolidate their accounts, and to own more stocks rather than fewer.
Providing Pensions Become Less Attractive
The Senate seeks to reward small-business owners by reducing their taxes, so that those who own these companies will pay a lower federal income-tax rate than their employees.
However, cutting a business owner's tax bill decreases her incentive to sponsor a US pension plan. As the American Retirement Association has noted, under the Senate's proposal, a business owner may end up paying up to 35% tax on retirement savings in a company pension plan, or 401k personal pension scheme.
If so, she is less likely to offer such a plan to her employees. Business owners sponsor company retirement plans for many reasons, many of which are unrelated to their personal finances, but their own investments certainly affect the decision.
As Morningstar's Aron Szapiro says: "Unlike most other countries, the US uses tax policy to motivate companies to offer their workers retirement plans. It is fine to change the mechanism; many observers argue, with good reason, that prompting actions through tax policies creates side effects, and is not the best path to take. But if tax policy is taken away, there needs to be a replacement."
A Sharp Drop in US House Prices is Possible
The bill might also depress housing prices enough to affect the stock market. There is no doubt that the tax-reform proposal will reduce home values. Both the House and Senate versions limit property-tax deductions, and they each also chip away at mortgage deductions. As the bills only take from property and do not give back, there is only one direction that home prices can take.
The question is, how large will be the decline? That we can only guess. The National Association of Realtors says the blow will be severe, at 10% to 30%. One should take the estimates of lobbying organisations with extreme caution. But, worryingly, Morningstar's Szapiro has arrived at a similar estimate.
So, a sharp drop in housing prices is possible. If that were to occur, I would expect the sort of knock-on effects that the US suffered in 2007-08, when slumping home values weakened consumer demand, thus slowing the overall economy, injuring corporate profits and taking down stock prices.
Others have argued the opposite, that stocks would rise because they would appear the better investment alternative to property. They could be correct. Suffice it to say that declining home prices would be disruptive.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
