2018 taxes and the markets

ROCHESTER, NY -- The 2016 election of Donald Trump awakened capitalism in the United States with hopes of less regulation and lower taxes for corporations. President Trump's mandate that every new regulation must eliminate two regulations is a simple yet effective way to maintain regulatory control while reducing some of the burdens of onerous regulations.

The biggest beneficiary of tax reform is the C corporation, most of which are publicly traded. To oversimplify, C corporations are taxed separately from their owners; with S corporations, also called "pass-through" entities, no income tax is paid at the corporate level. With the new tax changes, C corporation tax rates will be slashed from 35 percent to 21 percent. This is what has been a key driving force propelling the equity markets into making so many all-time highs.

In general, markets look ahead of economic activity and discount future economic activity, which means that markets are usually 9 months to a year ahead of the economy. Since the 2016 election of President Trump, the U.S. markets are up about 32 percent. We are on pace to be up 27 percent for 2017. The 3 percent plus GDP growth should accelerate next year. What is so amazing is this market move, which is the fourth best of any president's post-election year and the Dow Jones Industrial Average (since 1833), comes on top of a nearly 8-year bull market under the Obama years that began in March 2008. This is the second-longest bull market in history and many valuation metrics are historically high.

With all of this said, more wealth has been created in 2017 than under any other first-year president. American businesses, particularly C corporations, have and will benefit the most. Although many may have anticipated a cut for C corporations, I don't think very many people thought the tax rate for C corporations would be lowered from 35 percent to 21 percent.

At 21 percent it is slightly better for a "C" corporation to pay the corporate tax rate and dividend out of the remaining dollars rather than pay out salary to the owners. In fact, there is a benefit of about $.43 per $100 dollars ignoring state taxes but considering the cost of Medicare.

What are corporations likely to do with the extra 14 percent not going to the government? The four most likely beneficiaries will be:

- Shareholders through higher dividends or increased buy backs

- Consumers through lower prices of goods or services

- Employees by hiring more workers

- Employees by increasing wages

- Combined, each of these actions should result in significant economic growth. Prosperity and productivity should also rise meaningfully.

Last week, a friend of mine pointed out studies from independent organizations that were saying that the personal part of the tax cut package benefits the rich more than the middle class. I told him that those organizations were correct in one way, but misleading in another.

First of all, it must be understood that the top 10 percent pay 70 percent of the federal income taxes and the top 1 percent pay 39 percent. Thus, in terms of dollars, the middle class gets less. However, that is misleading because the percentage increase to the pockets of the middle class is much greater.

Furthermore, an extra 5 percent or more of the population will no longer pay any federal income tax. In fact, if you define the middle class as the middle 60 percent of Americans, you will find in 2018 that half of them will not pay any federal income tax.

Last, the top .5 percent of 1 percent will pay more if they live in relatively high tax states but are benefiting the most because of their investment returns. Therefore such individuals should accelerate deductions this year.

The "homerun" for businesses is the C corporation tax rate being cut to 21 percent. I think this will do a lot to stimulate the U.S. economy and has not been fully discounted.

In looking at 2018, I urge investors to remember that the trend is their friend! Up is the path of least resistance for our markets and it could be extremely costly for investors that try to time the markets. However, I do think that it would be prudent for investors to respect the high valuations by reducing equity market exposure through rebalancing to their well thought out, long-term asset allocations.

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George W. Karpus is Chief Investment Strategist and Chairman of the Board of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680.

Published: Fri, Dec 29, 2017

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