Sinema Speaks, Delivering Inflation Reduction Act Tweaks

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Alas, we have reached August—the notoriously slow news month when most governments are in recess and people worldwide are trying to squeeze in one final vacation before the kiddos go back to school. That doesn’t mean nothing happens, of course. But we do think it kind of explains why even slight changes to draft legislation can get heaps of attention. So it went Friday with the artist formerly known as Build Back Better (BBB) and now titled the “Inflation Reduction Act” (IRA^[i]), which received centrist Senator Kyrsten Sinema’s (D-AZ) backing after a few tweaks to the package of tax changes, climate and healthcare spending that moderate Joe Manchin (D-WV) hashed out with Majority Leader Chuck Schumer last week. As we write, most observers expect swift passage, perhaps as soon as late Sunday or early Monday. That could prove a touch optimistic, but regardless: Given the outsized attention and chatter about their potential impact on stocks, the bill’s main tax provisions seem worth a look.

To pass, the bill will first need the Senate Parliamentarian’s approval to enter the reconciliation process, which would enable it to pass on a simple-majority, party-line vote. That remains up in the air. Senate Parliamentarian Elizabeth MacDonough remains holed up in her office reviewing the draft legislation, and Congressional aides from both sides of the aisle are reportedly parading through to lobby her. (We have the utmost sympathy for her current ordeal.) For spending measures to qualify, they must be strictly budgetary, not policy changes dressed up as budget items, and some observers suspect pieces of the climate and healthcare provisions won’t qualify. If the bill clears that hurdle, then it needs unanimous support from Democratic Senators, which doesn’t seem certain yet. Manchin hasn’t yet weighed in on the changes Sinema drove, which remove one tax provision he wanted (eliminating the carried-interest provision) and add one he seemingly nixed several months ago (an excise tax on stock buybacks). This could be an unsolvable impasse. Even if it isn’t and the bill clears the Senate, its path in the House isn’t clear. The IRA is far removed from the version of BBB that passed in the House late last year, and it could be too watered down for some lawmakers’ tastes. It also doesn’t remove the cap on state and local tax deduction, which several Democratic lawmakers have demanded. Maybe this sails through, but we aren’t sure it will be so easy.

Popular opinions on the bill generally fall into two camps: One seeing it as a package of deleterious tax hikes, and one seeing it as a win-win of output-boosting spending and deficit reduction. We think both positions are overly extreme and see the whole package as largely benign. Not because its provisions are inherently fine, but because it has zero surprises. Everything in it has been discussed to death for a year or more, and the final package is watered-down greatly from initial proposals, as we wrote in late July. Plus, simply passing the thing would end uncertainty over what will change, enabling markets to move on. The combination of less-sweeping-than-expected legislation and falling uncertainty should be a tailwind.

For instance: If the IRA does become law with all of Sinema’s changes intact, it would exclude the carried interest tax hike that was in the Manchin/Schumer compromise. This is the tax code provision that lets private equity managers (and their ilk) pay partnership income from these funds at capital gains rates versus income tax rates. Therefore, to the extent that iteration shifted the tax code and effectively hiked rates on individuals above certain income thresholds, those are gone now. Sinema argues this will boost private equity firms’ ability to invest in the projects outlined in last week’s CHIPS Act and the infrastructure bill passed a while back, which might be true at the margins, although we wouldn’t overstate the potential benefits here. The main significance is extending the debate over the validity of this tax code provision yet again, as it seems to pop up with great regularity in campaign years. To the extent people feared this tax change affecting investment, it likely alleviates that, too.

The proposed minimum corporate tax rate also got watered down in order to secure Sinema’s approval. The original version was a 15% rate applied to companies’ book income—meaning, the earnings they report to shareholders—if their annual profit exceeds $1 billion. While this rate isn’t terribly high, it would raise revenue because companies’ financial income often exceeds their taxable income. Politicians have long griped about this, seeing the difference between these figures as tax-avoidance shenanigans and an uptapped gold mine. That betrays a fundamental misunderstanding of financial accounting and why the figures are different—and why many businesses argued the new tax would hit domestic manufacturers hard.

When companies’ book income differs from the income they report to the IRS, it isn’t because they are hiding revenue streams and inventing costs to secure a lower tax bill. Rather, the standards are different. To calculate the financial results reported to shareholders, companies use Generally Accepted Accounting Principles (GAAP), which are set by the Financial Accounting Standards Board (FASB). The goal is to give investors clear insight into a company’s revenues, costs and overall financial health. So it includes rules like real-time depreciation of capital equipment and other similar assets, marking them down as they decline in productivity over many years. The tax code, by contrast, generally aims to maximize the government’s revenue while encouraging investment and offering incentives in line with what the politicians who write it favor. Those incentives include the accelerated depreciation of capital equipment, which lets companies expense the entire investment up front—a tax incentive to boost capital expenditure and encourage more investment.

After the Manchin/Schumer draft appeared last week, there was a flurry of opposition from advanced manufacturers, which argued losing the tax benefit of accelerated depreciation would discourage capex and cause American factories to fall behind the world technologically. Hence, Sinema won a carveout preserving this deduction—easing another fear. We aren’t saying this is the best-case outcome: We think taxing companies’ book income opens a can of worms in the long run, as it transfers control of the corporate tax code from Congress to the unelected FASB, removing accountability and transparency. It therefore potentially pushes some tax rule changes into the shadows, which could inject more uncertainty long-term. It wouldn’t shock us if this ultimately wended its way through the courts to see if the Justices agree. But in the meantime, considering companies are quite familiar with GAAP standards and the new rules wouldn’t even apply to the entire S&P 500, let alone every publicly traded company, we doubt it qualifies as a fresh wallop. Not when markets have been pricing it in for over a year and a half now.

The same goes for the small 1% excise tax on stock buybacks. Yes, as a general rule, the more you tax something, the less you get of it. So in principle it is an incentive against stock buybacks. But buybacks have always been a cost/benefit calculation for companies, and we doubt a small penalty changes the calculus much provided the long-term return makes it worthwhile. Even if we do get fewer buybacks, those alone haven’t propped up stocks over the years. They are merely one check on overall stock supply and one way of returning cash to shareholders. Perhaps the upshot will be more dividends. Mind you, we find the change a bit silly, considering we have never seen compelling evidence that buybacks detract from capex, but political narratives often don’t need reality to underpin them. 

Rounding out the tax fears, we have the proposed methane-emissions tax, included in the IRA in the name of encouraging oil and gas firms to reduce emissions. Even though the bill tried to sweeten this with subsidies for emission-reduction efforts, industry leaders argue it is a headache that could discourage investment in oil and natural gas—a theme that seems to have gained traction, considering the widespread portrayals of the IRA as overall negative for Energy stocks. In our view, that ignores the bill’s mandate to reopen leasing in the Gulf of Mexico and elsewhere—and glosses over the fact that it was brokered by Senator Manchin, who represents a fossil fuel state. Even if the bill did discourage production, Energy firms’ earnings are tied to oil and gas prices, not production volumes, so the change probably wouldn’t punish earnings at all. That may not be great from a gas price point of view, but it seems hard to argue any of this is inherently bad for Energy earnings.

Overall, we see these tax tweaks as a mixed bag that creates winners and losers—but is too watered down and too widely expected to make waves in the market from here. Are there some new headaches for businesses? Probably. But there are also plenty of areas where those headaches won’t be as bad as feared. Most importantly, ending the will-they-or-won’t-they lets investors get over the uncertainty and enjoy the increased gridlock that likely follows midterms.