The air is abuzz with talk of tax reform. It was a key plank of President Trump’s campaign, and it could become a reality with a Republican-controlled House and Senate. On February 2, 2017, President Trump promised he would unveil a “phenomenal” tax plan in the next few weeks. It’s not just the substance of tax reform that matters; it also has symbolic importance. The proposal could signal a more pro-growth stance with the expectation of other policies to come. That’s one reason the market might seem to put a lot of weight on even hints of tax reform: the general business climate might become much more conducive to growth.

The new administration and the Republican-controlled Congress have floated many different proposals, so it is hard to say what tax reform will do when we do not know how it will be designed. The old saying is that the devil is in the details. That is especially true with tax code changes.

The top corporate rate has been flat for decades

The last time the top marginal federal corporate tax rate changed was in 1993, when it rose from 34% to 35%. That relatively small increase had dramatically different effects on different companies, particularly on small cap stocks. Before the increase, the weighted median tax rate of small cap stocks (represented by the Russell 2000) was 34.13% (higher than the then-prevailing federal rate due to state taxes) while the weighted median tax rate of large cap stocks (represented by the S&P 500 Index) was 28.10%. As a percentage of revenue, large cap companies tend to have more than 40% more of their revenue from foreign sources where taxes can be much lower, so that can explain some of the difference in the effective tax rates.

The effects of the 1993 corporate tax increase were profound and small at the same time. It profoundly affected many different firms in many different ways, but the aggregate effect was fairly small. The weighted median tax rate on small companies jumped to 40.57%, but large caps’ effective tax rate was relatively unchanged. As investors assess the upcoming tax proposals, they should remember that even a small change in tax rates can have a big effect on the financials of small firms.

The marginal tax rate is important for making decisions about new investments. Lowering the marginal tax rate should make it more attractive to invest for growth in the U.S. The effective tax rate can also be important as it affects available cash flows to pay various stakeholders.

Rates are only part of the picture

It’s not just the rates that matter. It’s the whole design of the tax code that matters. Where are the brackets set? What’s deductible and what’s not? How is investment spending treated? How is interest expense treated? Do different industries get special treatment? Does it matter where revenues come from? These are all open questions.

While the open questions are important to precisely figuring out who the winners and losers will be, I think there are some broad conclusions we can make: smaller firms that have their expenses mainly from U.S. sources, but revenues from foreign sources will likely do best.

The average effective federal tax rate on taxable income (which is not necessarily the same thing as net income) was 23.3%, according to 2013 corporate tax data from the IRS (the most recent available). Firms with lower revenues tend to have higher tax rates than firms with larger revenues. For firms with revenues in excess of $250 million, the average tax rate was 22.5%. In 2013, the weighted average sales of firms in the Russell 2000 was $1.57 billion. So, publicly traded small cap companies are actually quite large compared to all the corporations in the US.

Different sectors are affected differently by the tax code, as well. It depends on the deductions they can take, the sources of revenues, and the use of debt.

Highest taxed sectorsTaxes as a % of net income
Health Care and Social Assistance34.0%
Agriculture, Forestry, Fishing, and Hunting33.7%
Educational Services33.2%
Transportation and Warehousing32.2%
Lowest taxed sectorsTaxes as a % of net income
Management of Companies (Holding Companies)15.5%
Accommodation and Food Services16.0%
Manufacturing18.1%
Mining18.1%
Source: Internal Revenue Service
On balance, tax reform would seem to benefit smaller, more domestically oriented-firms simply because they seem to have the highest tax burden. But where their goods and services are sold also matter. If there’s a border adjustment tax, then those firms that export could benefit more.

Taxes and the trade debate

There’s a new twist with the tax reform debate: the border adjustment tax, which would exclude exports from taxable income revenues. The proposed tax would also disallow firms from deducting the cost of any imports as an expense. This too could create winners and losers. The firms that would likely do best with a border tax adjustment would be those that source things domestically but sell internationally (for example, agriculture and extractive industries along with service firms with foreign clients). The firms that would likely do worse would be those that import their inputs and sell to domestic consumers (for example, clothing, groceries, and furniture retailers).

But we don’t know exactly what form tax reform will take. Even if it creates a net benefit overall, all changes create relative winners and losers.

Lower tax rates could lead to lower debt supply too

There’s another angle to tax reforms that affects fixed income investors. To the extent that it frees up cash for businesses, lower taxes can improve the overall credit quality of many issuers. The less a business pays in taxes, the more it has to pay debt holders. Lowering corporate tax rates makes it marginally less attractive for firms to issue debt. Firms tend to like debt thanks to its tax advantage—it’s considered an expense when calculating income and taxes. Lowering rates means firms—at least on the margin—could find financing their business with equity more attractive. Less debt supply means interest rates could be lower than they otherwise would be.

However, some of the tax reform plans propose removing the deductibility of interest expense for businesses. Since the early 1900s, interest expense has been deductible. This has, arguably, led businesses to rely more on debt financing than they otherwise would. Eliminating the deductibility of interest expense wouldn’t eliminate debt as an option for financing—debt typically comes at a lower cost as investors like the contractual obligations to pay back the debt—but it would likely further reduce the incentive to issue debt.

Right now, tax reform hasn’t really formed into a published plan that can be analyzed. There are a lot of what ifs and maybes. The most conclusive thing I can say about it is that smaller firms are likely to benefit more than larger firms. Reforms would also likely help keep interest rate spreads narrow in the fixed income markets.

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