While no longer inevitable or even likely, higher corporate tax rates are still possible.
With the election and its potential ramifications still in focus and in flux, we’re going to stick with that topic this week but drill down on one specific aspect that is of strong interest to market observers of banks and bank stocks. Just quickly on the backdrop: Heading into the election, the talk was that in a “Blue Wave” scenario, an increase in corporate tax rates – to 28% from 21% — was a foregone conclusion. Subsequently, however, with the prospect of divided government now more likely, higher corporate tax rates no longer seem inevitable, but are still possible, with the outcome probably dependent on the results in early January of the Georgia run-off elections, which will determine control of the Senate.
There is no denying some of the negative ramifications of higher tax rates…
Setting the political aspect of the issue aside, my take is that the hand-wringing over this topic is overdone, even if the “bad case” scenario were to play out for banks and tax rates increased. On the one hand, there is no doubt that the surface aspects of a tax hike for banks are negative, most notably the obvious EPS headwind it would present for next year and beyond. Indeed, tax rates at the level proposed would hurt EPS and ROTCE by about 7%-9% and 50-100 bps, respectively, for the average bank.
…but viewed more holistically, it’s not all bad!
However, and admittedly at the risk of falling down the rabbit hole of accounting jargon, there is a less obvious implication of an upward tax adjustment which in my view mitigates at least a portion of the negative impact. In simple terms, when tax rates went down, the vast majority of banks were required to write-down the value of their deferred tax asset, which for many resulted in a significant charge that hurt tangible book value per share. So in the event that tax rates are increased, the opposite would happen: banks would see an upward revaluation of the deferred tax asset, resulting in a potentially sizeable boost to tangible book value, at a time when investors are honing in intently on this valuation metric (with valuation based on earnings relegated to an after-thought), as is so often the case during a time of economic crisis.
So why the focus on the “bad” aspects of a tax hike and not the “good”? A few reasons, in my opinion.
- First, let’s be honest, and no offense to the accountants, the topic of potential offsets to a tax increase is boring, complex, and certainly not a “headline grabber”, at least not to the same extent as a byline stating that earnings are heading lower.
- Second, with respect to the potential DTA write-up (and resultant impact to TBV), there isn’t a uniform standard or screening technique that can be simply applied across the sector to help assess the impact. One would have to sift through 4Q17 earnings reports bank-by-bank to determine the impact of the DTA writedown at the time, and even then, for many reasons that we won’t walk through in this piece, the reversal of that write-up now wouldn’t necessarily match the initial writedown. By contrast, the impact to earnings from a tax hike is fairly straightforward. Hence, the earnings impact is easily quantified and has been publicized, whereas the offsetting consideration is not easily measured and more complex, and thus hasn’t been talked about nearly as much.
If the stocks didn’t really benefit, should there now be a penalty?
The other aspect of this argument that really doesn’t compute for me is the notion that stock prices should adjust to the downside if higher tax rates become a reality. In theory, this makes sense, as P/E multiples will increase by nearly a point if new legislation comes to pass. The issue with this analysis however, is that it assumes that the stocks sustainably benefited from lower tax rates in the first place. While bank stock prices moved markedly higher following the 2016 election, there were a variety of reasons for the move, and it wasn’t sustained for the long-term, as sector stock prices began a precipitous decline in mid-2018. In fact, an analysis we did at the time showed that bank stocks were trading at lower-than-normal P/E multiples, but if adjusted for the differential and recent change in tax rates, were trading more in line with the historical average. So the conclusion was that lower tax rates were never really sustainably embedded in bank stock valuations, I think because the market correctly intuited the risk we were due to face in the 2020 election: that the decline in tax rates was perhaps only temporary. So if the stocks didn’t really benefit all that much from tax relief in the first place, why should they now be penalized?
Bottom line, the hand-wringing on this topic in my opinion is overdone and it’s time to move on.
Joe Fenech is the Managing Principal of SMBT Consulting, LLC, which provides consulting services to banks. Mr. Fenech is also the Chief Investment Officer and Managing Member of GenOpp Capital Management LLC, a regulated investment adviser in the State of Indiana. The article represents the views and belief of Mr. Fenech and does not purport to be complete. The information in this article is provided to you as of the dates indicated and the data and facts presented herein may change. You should not rely on this article as the basis upon which to make an investment decision; this article is not intended to provide, and should not be relied upon for, tax, legal, accounting or investment advice.
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