Thornburg Investment Management
January 24, 2018
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Tax Reform Moves the Needle on U.S. Corporate Tax Competitiveness

If U.S. tax reform modestly boosts economic growth and deepens the fiscal deficit, its benefits for smaller companies are significant. It also ends incentives that spurred bigger U.S. firms to decamp to lower-tax jurisdictions abroad.

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The tax overhaul is the most sweeping in decades and puts most
U.S. firms on more competitive footing vis-à-vis overseas corporate
tax regimes. Smaller businesses with a domestic focus and little abil
-
ity to lower their effective tax rates will benefit the most. Many com
-
panies should have more scope to invest, raise wages, cut prices,
pay down debt, or return the tax savings to shareholders. The reform
could affect corporate capital structures. It could even impact finan
-
cial sector holdings of municipal bonds. But just how much it adds to
economic growth and the fiscal deficit and how it figures into mone
-
tary policy, remains to be seen.
Featured Inside
• The tax reform, along with the reduction in regulation, should modestly boost economic growth,
particularly over the next few years. But it could also add to the fiscal deficit and federal debt
load at a time of rising benchmark interest rates, possibly reducing the economic tailwinds.
• The tax reform should be more inflationary than deflationary. Given that valuations for most
assets—including U.S. equities, as well as high-yield and investment-grade debt—are on
the richer end of fair value, the margin for error appears limited.
• But a lower cost of capital should stimulate investment, increase productivity growth, and
raise potential gross domestic product. Lifting long-stagnant productivity growth is the key to
rising wages. Small businesses, which account for nearly two thirds of net new jobs, should
especially benefit from lower taxes.
• The reform’s shift to a territorial from a worldwide-taxation system should reduce tax inver
-
sions by U.S. corporates, which will also have to pay one-off taxes on their past earnings
parked overseas.
Tax Reform Moves the Needle on
U.S. Corporate Tax Competitiveness
Januar y 2018
Charles Roth | Global Markets Editor
The U.S. has passed its biggest tax reform
in more than three decades, meaning
-
fully raising the tax code’s competitiveness
in the world’s largest economy. The $1.4
trillion, 10-year overhaul cut the corporate
income tax rate to its lowest level in nearly
six decades, while most individuals will also
see smaller federal assessments on their
earnings.
The package is likely to lift economic growth
0.2 percentage points to more than 0.4 per
-
centage points in 2018, with projections for
2019’s boost ebbing a bit, as the reform is
relatively front-loaded. Its long-run fillip to
gross domestic product (GDP) is projected
anywhere from 0.7%, according to the Joint
Committee on Taxation’s static-scoring
forecast, to the Tax Foundation’s dynami
-
cally scored 1.7%.
Such forecasts are always slippery. Incentive
effects that spur greater corporate invest
-
ment and consumer spending will also spur
faster economic growth, but how much
it offsets the revenue loss of lower taxes is
hard to predict. Any shortfall will result in
higher budget deficits without lower gov
-
ernment spending. Yet fiscal outlays are
likely to increase due to rebuilding efforts
following a heavy 2017 hurricane season
and the Trump administration’s broader
push to boost infrastructure spending. That
suggests the plan won’t be revenue neutral
anytime soon, deepening the fiscal deficit by
a point or two from 3.5% of GDP at the end
of 2017 and further increasing federal debt
that is already more than 100% of GDP. A
heavier debt load would also come at a time
of rising benchmark interest rates, which, in
addition to raising interest costs on the debt,
also factor into the pace of GDP growth.
The Federal Reserve is expected to hike
three to four times in 2018, pressuring the
short end of the yield curve at the same
time that it’s gradually reducing the size of
its balance sheet. The “quantitative tight
-
ening” will continue amid two more slated
key rate hikes in each of the following two
years. A more aggressive Fed could slow the
economy, which would then spin off less tax
revenue. At its December meeting, the Fed
raised its 2018 GDP forecast four-tenths of
a point to 2.5%, even as the economy has
lately been running well-above that pace: in
the April-through-September period, it was
chugging at more than 3% annual growth.
Yet the Core PCE Index, its preferred infla
-
tion measure, hasn’t been close to the 2%
target for nearly a year, despite unemploy
-
ment receding to 4.1%.
Some argue that slack remains in the labor
market. The labor participation rate is still
at four-decade lows. And, as Deutsche
Bank’s Torsten Slok points out, the main
reason long-awaited wage growth has been
slow to materialize is that people have been
more or less steadily returning to the labor
market since 2013, easing the pressure on
employers to hike salaries. Given the econ
-
omy’s momentum, the Fed expects the labor
market to tighten further, forecasting 2018
unemployment of 3.9%.
The tax reform and the White House’s
deregulation efforts create tailwinds for
employers to invest in both labor and cap
-
ital. Major companies, including AT&T,
Comcast, Fifth Third Bancorp, The Home
Depot, and Walmart, among others, have
already declared increases in entry-level
salaries, bonuses, or investment spending.
Critics of the reform point out that major
companies already had a lower effective
corporate tax rate thanks to loopholes and
accounting wizardry. But proponents note
that smaller businesses, which account for
about half of private sector payrolls and
nearly two-thirds of net new jobs, should
benefit from lower taxes and a more level
playing field. All in all, as the Fed’s out-go
-
ing Janet Yellen noted in her last remarks as
chairwoman to the press, the tax overhaul
should lower the cost of capital, stimulate
investment, increase productivity growth,
and raise potential GDP. Lifting long-stag
-
nant productivity growth is the key to lift
-
ing wages, and, potentially, inflation.
After the December policy meeting, Yellen
also pointed out that the
Tax Cuts and Jobs
Act
has “some potential to boost aggregate
supply.” It’s definitely a supply-side reform.
At 35%—or 39% including state taxes—the
nominal U.S. corporate tax rate was the
highest in the developed world. It created an
incentive for U.S. companies to relocate to
more competitive tax jurisdictions via merg
-
ers called tax inversions. The reform reduces
the rate to 21%, three points below the
average statutory corporate tax rate in the
Organization for Economic Cooperation
and Development. Businesses will also
enjoy an immediate write-off on capital
investments, and the corporate alternative
minimum tax has been eliminated.
The reform also moved the U.S. from a
world-wide taxation system, in which U.S.
firms were effectively taxed at the previ
-
ous U.S. rate on their foreign income, to a
territorial system, which only taxes income
earned within a country’s border. That’s how
most countries handle their multinationals’
foreign earnings. As a result of the U.S.’s
previous high corporate tax and world-wide
taxation approach, some $2.6 trillion in cor
-
porate profits are parked overseas. As part of
the reform, U.S. firms will be taxed on those
foreign earnings at a 15.5% rate, and an 8%
levy on other, illiquid assets abroad. U.S.
banks, tech and pharmaceutical companies
with world-wide operations will be hit with
billions of dollars in one-off charges. As
noted, many had a lower effective tax rate,
and so won’t see as much benefit from the
tax reform as their smaller domestic peers.
Yet by forgoing convoluted, tax-driven
domicile and financial engineering strate
-
gies, over the long run they could also come
out more or less even, or potentially ahead
with the lower domestic corporate tax rate
and territorial tax system.
On the individual side, most people mak
-
ing tax payments will see tax cuts over
the next few years, though after 2021, the
Joint Committee on Taxation warns some
low-income taxpayers might effectively see
a net tax increase due to the elimination of
the Affordable Care Act’s individual man
-
date and subsequent cut in health insurance
subsidies. They number an estimated 5%. In
2019, nearly a quarter of the aggregate tax
cut—about $61 billion, or an average cut of
$1,600—will go to middle-income earners
making between $20,000 and $100,000 and
representing about half of all tax filers. Given
the progressive structure of the tax system,
the bulk of the tax cut will go to higher-in
-
come groups, with 52% headed for those
with incomes of $100,000 to $500,000.
Around 23% will go to the “one-percenters”
making more than $500,000 per year.
As for the debate over the contribution
to GDP growth from increased personal
consumption as a result of more dispos
-
able income through the tax cut, it’s worth
noting that, at 2.9% in November, the U.S.
personal savings rate is at its lowest level
in a decade. Higher-income groups might
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Tax Reform Moves the Needle on U.S. Corporate Tax Competitiveness
Tax Reform Moves the Needle on U.S. Corporate Tax Competitiveness
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save or invest more of the tax savings than
spend it. In any event, the Conference
Board’s Consumer Confidence Index rose
to its highest level in November since 2000.
Animal spirits have also been stoked, with
the National Federation of Independent
Business Optimism Index nearing a record
high in November, a level it nearly matched
in December and making 2017 the highest
year on record. Investors clearly like what
they see in the tax reform, driving U.S.
bluechip equity indices to record highs in
anticipation of the tax reform, and in the
weeks following it, as well.
As a bottom-up investment shop, Thornburg factors tax rates into its model assumptions as just one
element of its fundamental securities analysis. Thornburg’s Christian Hoffmann,
cfa
, Rob McDonald,
cfa
, and Nicholos Venditti,
cfa
, weigh in on the discreet impacts the tax reform should have in particu
-
lar sectors of the market and for investors.
Q:
The spread between 10-year and two-year
U.S. Treasuries has compressed since the
beginning of 2014, shortly after the Fed first
flagged the “tapering” of quantitative eas
-
ing and subsequent, albeit gradual, rate
hikes. Historically, a flattening yield curve
often portended an inversion in the curve,
followed by recession. Do current economic
conditions and the tax reform suggest that
this time is different? Also, after consider
-
able tightening in high-yield and high-
grade corporate spreads in 2017, how much
lower can spreads go in 2018, especially
given liquidity risks associated with the
Fed’s monetary tightening.
Christian Hoffmann:
Undue emphasis on
any one data point or ratio ignores the com
-
plexity and interconnectivity of the global
economic landscape. Much has been made
of the flattening yield curve, but the flatten
-
ing has been driven by rising short-term
rates, which have been driven by Fed actions
that the vast majority of investors believe are
long overdue. Interestingly, the 10-year
Treasury ended 2017 almost exactly where it
started the year.
The Fed increasing short-term rates should
assuage inflation fears, which are most
apparent in the longer end of the yield
curve. It’s worth mentioning that investors
are still taking a relatively sanguine per
-
spective toward inflation risk and that at
the margin, tax reform should be more
inflationary than deflationary.
Another factor to consider is the global mar
-
ketplace for assets. Compared to the vast
majority of the world, Treasuries still offer
compelling relative value among govern
-
ment debt issuers—remember that 10-year
German bunds yield not even one-fifth of
10-year Treasury yields.
The world of early 2018 points to an environ
-
ment of reasonable global economic growth
and subdued inflation. On the other hand,
valuations for most assets—including U.S.
high-yield and investment-grade debt—are
on the richer end of fair value. The margin
for error appears limited. It seems fairly clear
that we are in the later innings of an eco
-
nomic cycle, and there is virtually an endless
list of events that could disrupt-to-nega
-
tively shock the marketplace.
Q:
In recent years, U.S. businesses have bene
-
fited from the “bonus depreciation deduc
-
tion” of 50% on new equipment, and aggre
-
gate non-residential fixed investment has in
fact been growing since mid-2016. While
the reform’s 100% expensing of capital
investment over the next five years will
include both new and acquired equipment,
do you expect much of an increase in aggre
-
gate corporate investment?
Rob McDonald:
I would expect a modest
increase in corporate investment due to the
change in tax treatment for equipment. The
tax law change will pull forward some pur
-
chasing that would have taken place at a
future date. On the margin, overall equip
-
ment demand could increase a
little—equipment purchases that didn’t quite
make the return hurdle historically—may
make sense post tax reform.
Q: Do you anticipate a decrease in tax inver
-
sions, given the lower U.S. corporate income
tax rate and the move to a territorial from a
worldwide taxation regime?
Rob McDonald:
I would expect a decline in
tax inversions going forward. The govern
-
ment has tried to prevent companies moving
abroad for some time. This tax reform plan
decreases the attractiveness of domestic com
-
panies moving out of the United States.
Q:
The U.S. retail sector pays an average corpo
-
rate tax rate of about 31%, as retailers gener
-
ally import many of their products and can’t
deduct much from research and development
initiatives. So the sector, much of which has
come under pressure from the “Amazon
Effect,” stands to benefit. Do you expect
retailers to lower product prices to better
compete, or do you think they might gener
-
ally use the tax savings to pay down debt,
invest or return more of it to shareholders?
Rob McDonald:
In thinking about financial
impacts of tax reform, the first question is
how much a company’s tax rate will decline.
The second question is, can that company
keep the savings or does it have to give it to
customers? Retail is a tough business, where
you have to evolve or die. Some of the tax
savings will have to be passed along to con
-
sumers through lower product price or
investments in stores.
Q: The net interest deduction is now capped at
30% of EBITDA for four years, and 30% of
EBIT thereafter, ending the full deduction
of interest payments. Do you expect that this
will push more companies, particularly
non-investment-grade corporates that are
generally subject to higher interest rates on
debt issued, to finance themselves less with
debt versus equity going forward?
Rob McDonald:
The new tax law will push
company capital structures to a higher mix of
equity and lower debt.
Q: In the prelude to the tax reform, the munici
-
pal bond market saw a gusher of issuance,
with sales of both refinancing and new
paper in December alone totaling approxi
-
mately $64 billion, a record high. Prices
plunged relative to U.S. Treasuries on the
supply wave, only to climb back up as inves
-
tors snapped up the lower-priced munis. In
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Tax Reform Moves the Needle on U.S. Corporate Tax Competitiveness
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or sum-
mary prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read them
carefully before investing.
Thornburg Funds are distributed by Thornburg Securities Corporation.
© 2018 Thornburg Investment Management, Inc. | 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 877.215.1330
1/17/18
TH4085
its final version, the tax reform did away
with the exemption on advance refunding
bonds, which cities and states use to refi
-
nance older debt, but retained the exemption
on private-activity bonds, which non-prof
-
its and some for-profits turn to for projects
deemed of public benefit. Are fears of less
muni market supply ahead as a result of the
end of advance refunding bonds warranted?
Also, marginal rates on top earners,
although a bit lower with the tax reform, are
still relatively high. Coupled with the new
$10,000 limit on state and local tax (SALT)
deductions for married couples (and $5,000
for individuals), do you expect more taxable
income to shift to low or no income tax states
from high tax states?
Nicholos Venditti:
I am not convinced that
the elimination of advanced refunding bonds
will have a material impact on supply in the
short term. While it is certainly true that
refunding bonds have been a major driver of
supply over the past several years, it is import
-
ant to remember that the economic benefit of
refunding debt is predicated on lower interest
rates. To the extent that we believe rate pres
-
sure is shaded higher, the market likely would
have seen substantially less advanced refund
-
ing issuance in the near term, regardless of
tax reform.
The issue of outmigration is more inter
-
esting, albeit a longer-dated problem.
Demographic trends have long been a
cornerstone of credit analysis. Population
declines have had a material impact on issu
-
ers in the past, largely due to the death of
manufacturing. The financial problems in
places such as Detroit, Buffalo, steel towns
in Pennsylvania, and even Puerto Rico, all
have been exacerbated by loss of the tax base.
An increased tax burden that encourages
people to vacate for greener, or in this case
cheaper, pastures is absolutely a possibility.
But the SALT limit and a lower cap on
mortgage interest deductions actually
make munis that much more attractive
for high-income individuals. And that, in
turn, partially offsets the negative impact
that the lower corporate tax rate has on the
muni market, of which banks and property
and casualty insurers own roughly 15% and
10%, respectively.
The tax reform’s repercussions on relative
valuations and risks in the muni and other
markets once again highlight the absolute
necessity of quality, fundamental research.
At Thornburg, we have built a 30-plus-year
franchise focused on disciplined, bottom-up
analysis and are more than equipped to nav
-
igate the changing market dynamics.
n
IMPORTANT INFORMATION
The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or
investment advice and is not intended to predict the performance of any investment or market.
Alternative Minimum Tax (AMT) – A federal tax aimed at ensuring that high-income individuals, estates, trusts, and corporations pay a minimal level income tax. For individuals, the AMT is calculated by
adding tax preference items to regular taxable income.
Animal spirits – A term coined by John Maynard Keynes to describe human emotion that drives consumer confidence.
Bond Credit Ratings (Credit Quality) – A bond credit rating assesses the financial ability of a debt issuer to make timely payments of principal and interest. Ratings of AAA (the highest), AA, A, and BBB
are investment-grade quality. Ratings of BB, B, CCC, CC, C and D (the lowest) are considered below investment grade, speculative grade, or junk bonds.
Consumer Confidence Index – The Consumer Confidence Index is an index by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the
near future.
Core Personal Consumption Expenditure Index is a measure of the Personal Consumption Expenditure Index that excludes the more volatile and seasonal food and energy prices.
Credit Spread/Quality Spread – The difference between the yields of securities with different credit qualities.
EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization. An approximate measure of a company's operating cash flow based on data from the company's income statement.
NFIB Small Business Optimism Index – The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of 10 seasonally adjusted components and provides an
indication of the health of small businesses in the U.S.
Quantitative Easing (QE) – An unconventional monetary policy in which a central bank purchases financial assets from the market in order to lower interest rates and increase the money supply.
P/E – Price/Earnings ratio (P/E ratio) is a valuation ratio of a company’s current share price compared to its per-share earnings. P/E equals a company’s market value per share divided by earnings per
share. Forecasted P/E is not intended to be a forecast of the fund's future performance.
Yield Curve – A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
Securities mentioned herein are for illustrative purposes only and are presented to describe the due diligence process for purchasing or selling an individual stock. Under no circumstances does the
information contained within represent a recommendation to buy or sell any security. This information is current as of the date indicated and represents current holdings of Thornburg; however, there is
no assurance that any security referenced will remain in any portfolio and Thornburg undertakes no obligation to update the information or otherwise advise the reader of changes in its ownership of the
holdings. It should not be assumed that any of the referenced securities were or will be profitable or that the investment decisions we make in the future will be profitable.
Investments carry risks, including possible loss of principal. Additional risks may be associated with investments outside the United States, especially in emerging markets, including currency fluctuations,
illiquidity, volatility, and political and economic risks. Investments in small- and mid-capitalization companies may increase the risk of greater price fluctuations. Portfolios investing in bonds have the
same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. This
effect is more pronounced for longer-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Investments in mortgage-backed securities (MBS) may bear additional risk. Investments
in lower rated and unrated bonds may be more sensitive to default, downgrades, and market volatility; these investments may also be less liquid than higher rated bonds. Investments in derivatives are
subject to the risks associated with the securities or other assets underlying the pool of securities, including illiquidity and difficulty in valuation. Investments in the Funds are not FDIC insured, nor are
they bank deposits or guaranteed by a bank or any other entity.
Fund Holding Weights as of 11/30/17
Thornburg Core Growth Fund:
Comcast, 2.05%, Walmart, 2.75%.
Thornburg Investment Income Builder Fund:
AT&T, 1.37%; The Home Depot, 2.21%.
Thornburg Limited Term Income Fund:
AT&T, 0.80%; Fifth Third Bancorp, 0.08%.
Thornburg Low Duration Income Fund:
AT&T, 0.88%; Fifth Third Bancorp, 0.89%.
Thornburg Strategic Income Fund:
AT&T, 0.22%; Comcast, 0.92%.
Thornburg Value Fund:
Walmart, 4.19%.
Companies mentioned in the article but not listed above were not held in the above-mentioned Thornburg funds as of 11/30/17.
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The views expressed by the portfolio managers reflect their professional opinions and are subject to change. Under no circumstances does the information contained within represent a recommendation to buy or sell any security. Investments carry risks, including possible loss of principal. Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity. Please see our glossary for a definition of terms: http://www.thornburg.com/legal/glossary.aspx Thornburg mutual funds are distributed by Thornburg Securities Corporation. Thornburg Investment Management, Inc. mutual funds are sold through investment professionals including investment advisors, brokerage firms, bank trust departments, trust companies and certain other financial intermediaries. Thornburg Securities Corporation (TSC) does not act as broker of record for investors.

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