INVESTMENT IMPLICATIONS OF TAX REFORM

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP89-00066R000400070053-6
• Release Decision: RIFPUB
• Original Classification: K
• Document Page Count: 2
• Document Creation Date: December 22, 2016
• Document Release Date: January 10, 2011
• Sequence Number: 53
• Publication Date: July 1, 1986
• Content Type: OPEN SOURCE

Approved For Release 2011/01/10: CIA-RDP89-00066R000400070053-6
Research Perspectives
Investment Implications of Tax Reform
After its remarkable resuscita-
tion in the Senate Finance Com-
mittee, Federal tax reform has a
good chance of becoming the law
of the land. The "reform" is re-
ally an economic revolution that
would leave no part of the U.S.
economy unaffected; even
though it raises corporate taxes
by about S108 billion over the
next five years, its overall impact
for investors in common stocks is
bullish. The reason: By lowering
tax rates and eliminating many
deductions, tax reform will en-
courage investors to make deci-
sions based on sound economics
rather than on their tax situation.
Capital will be invested more ef-
ficiently, interest rates will tend
to decline and the incentives to
work and to save will increase.
The position of taxable inves-
tors will be radically changed.
With marginal tax rates lower
and investment income taxed at
the same rate as capital gains,
whether long-term or short-term,
bonds and high-yield stocks be-
come more attractive compared
to municipal bonds, growth
stocks or real estate. And trading
options and stocks for short-term
gains increases in attractiveness
relative to holding for the long
term.
Structural Improvement
in the U.S. Economy
On its face, tax reform might
appear to be negative for equity
investors. With corporate taxes
raised by 20%.corporate cash
flow-which has facilitated mer-
gers and share repurchases-will
decline significantly. In the
longer run, however, tax reform
is positive for stocks. Inflation
and interest rates will decline and
the long-term economic growth
rate will be raised by eliminating
these major distortions in the
way capital is allocated in the
U.S. economy.
Under current law, the Invest-
ment Tax Credit (ITC) and accel-
erated depreciation create partic-
ularly low effective tax rates for
such capital-intensive industries
as autos, steel, heavy machinery,
paper and chemicals. Partly be-
cause they are capital-intensive,
these industries earn a lower re-
turn on capital than do such
service and light-manufacturing
businesses as food processing,
electronics, broadcasting, media
and financial services. Conse-
quently the tax system currently
favors investment in less profit-
able parts of the U.S. economy.
Elimination of the ITC, imposi-
tion of a minimum tax, a lower-
ing of the statutory corporate tax
rate and other changes will rec-
tify this distortion.
Another distortion is that tax
shelters, built around the ITC,
accelerated depreciation and the
ability to write off passive busi-
ness losses, lure large amounts of
capital into unproductive activ-
ities.
The third distortion is that the
50% marginal rate currently in
the personal tax code encourages
taxpayers to purchase homes or
apartments whether they need
them or not, subsidizes con-
sumption through tax deductibil-
ity of interest expense and pushes
wealthy individuals into tax shel-
ters. High marginal rates also
discourage working to earn addi-
tional money. In addition, they
discourage saving and raise the
rate of interest sought by individ-
ual investors.
The combined effect of these
changes is difficult to calculate,
but since Federal revenues cur-
rently amount to roughly one-
fifth of GNP the potential impact
is clearly enormous. And the
mere ability of the U.S political
system to produce such reforms
will increase both domestic and
foreign confidence in the U.S.
economy.
But this is not to say that the
plan is free of risk because some
parts of the U.S. economy work
very well under current fiscal; ar-
rangements. One of the few areas
in which the U.S. economy still
has an edge over its Asian com-
petitors is in commercializing
new technology. New industries
such as biotechnology and
microcomputers emerge from
government-financed university
labs and are then rapidly com-
mercialized by dozens of small
start-up companies financed by
venture capitalists. Most of these
start-ups either fail or are moder-
ate successes, but the few big
winners eventually are taken
public when the initial public of-
fering market heats up during
bull markets. Historical experi-
ence suggests that the success of
this system hinges on a favorable
tax rate on long-term capital
gains. The venture capital system
thrived in the bull market of the
late 1960s, when?capital gain
taxes were low; collapsed in the
bear market of the early 1970s,
when the capital gain tax prefer-
ence was eliminated and many
capable entrepreneurs could not
find funding in the U.S.; and
dramatically revived after 1978,
precisely at the time that the cap-
ital gain rate was pushed down
again. Can the venture capital
system, and high-tech America
in general, survive a tax reform
that has no special incentives to
invest in small start-up compan-
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ies? The answer will depend
largely on just how high the ef-
fective capital gain rate is in the
final bill.
Key Investment Issues
The effect of tax reform on
U.S. equities varies tremen-
dously among stock groups.
Precise analysis is impossible be-
cause details of the Senate pack-
age will change significantly in
coming weeks. It seems wise,
therefore, to focus on the major
issues of tax reform.
High-dividend stocks, such as
utilities, international oils and
food benefit because the tax on
dividends will decline, both ab-
solutely and relative to the tax
on long-term capital gains.
Conversely, volatile low-
yielding stocks, such as software,
biotechnology and semiconduc-
tors, are intrinsically less attrac-
tive investments if a seven-
month capital gain is taxed at the
same rate as interest income or a
quick jump in an option premium.
Among the businesses that fare
best are high-tax, consumer-
oriented industries such as retail-
ing, media, advertising, house-
hold products and retail
brokerage, which currently pay
out more than 40% of their in-
come in taxes. Certain firms will
see earnings rise 15-20%. An
added plus is that the individual
tax cut should modestly boost
consumer spending.
Companies that serve the real
estate market, both commercial
and residential, are hurt by the
Senate bill.
The tax burden of many
capital-intensive industries such
as utilities, chemicals and electri-
cal equipment will increase,
thereby reducing cash flow and
putting a damper on acquisitions
and share buybacks.
The Investment Tax Credit is
sure to be eliminated, effective
January 1, 1986. Any companies
that are using the ITC on equip-
ment put into place after that
date are, in effect, overstating
earnings and cash flow. Earnings
estimates for such companies will
be revised downward in coming
weeks.
Tax reform is negative for in-
dustries such as steel, heavy
equipment, machine tools, bio-
technology, airlines and semicon-
ductors that have not had profits
over the past several years; the
value of their net operating loss
(NOL) carryforwards and Invest-
ment Tax Credit carryforwards
will decline for a variety of rea-
sons. Since they are tax deduc-
tions rather than credits, NOLs
are automatically less valuable if
marginal tax rates decline.
While these various technical
effects are important, one must
remember that corporations are
not primarily in the business of
saving taxes. Although the tax li-
ability of many capital-intensive
companies will increase, causing
a near-term drop in cash flow
and perhaps earnings, the long-
term growth of revenues and
earnings will rise if the the U.S.
economy becomes more efficient
and competitive and long-term
GNP growth increases.
Thomas M. Doerflinger
Investment Strategist
June 13, 1986
Additional Information
This issue of Research Perspec-
tives has been excerpted from a
report entitled "Investment Im-
plications of Tax Reform" (View-
point No. 20). The full report in-
cludes PaineWebber analysts'
preliminary assessment of how
the Senate tax plan would affect
the industries they cover. For a
copy of this Viewpoint, call your
PaineWebber Investment
Executive.
The information contained herein is based on sources believed reliable, but its accuracy cannot be guaranteed. PaineWebber Incor-
porated and/or Mitchell Hutchins Asset Management Inc. and/or PaineWebber International Inc. and/or PaineWebber Real Estate
Securities Inc. and/or Rotan Mosle Incorporated, affiliated companies, and/or officers, directors, employees or stockholders thereo, .
may at times have a position, including an arbitrage or option position, in the securities, futures or commodities described herein
and may sell or buy them to or from customers. These companies may from time to time act as consultant to a company being re-
ported upon. This publication is not an offer to buy or sell such securities, futures or commodities. Money Notes copyright J 1986
PaineWebber Incorporated.
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