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Tax Reform: A Boon or Bane for Small-Cap ETFs?

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Chances of materialization of the tax reform (or cuts) this week are sky-high. If materialized, the step will mark a significant achievement for the Trump administration and his promise to deliver historic tax cuts for Americans by the end of the year.

The plan will slash the corporate income tax rates from 35% to 21% from next year and limit the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 20%. This rate is smaller than 23% stipulated in the Senate-passed bill. Needless to say, such provisions put small-cap stocks and the related ETFs in a sweet spot (see all small-cap ETFs here).

The logic is simple. Tax cuts will help corporations to generate more profits. Plus, realizing the tax cuts, people will likely boost its expenditure. Since small-cap stocks are domestically focused, these higher outlays will boost the business of the small corporations. After all, the blueprint offers tax relief to middle-class families by doubling the standard deduction to $12,000 for single filers and $24,000 for a married couple filing jointly. So, small-caps emerge as a natural winner.

But have you given it a thought that there are loopholes in the story. There are some factors in the tax blueprint that can go against the small-cap funds. We’ll tell you what these are.

Deterrents

As per an article published on thestreet.com, the current law entails full deduction of interest paid. The new law will hold companies back from relying on debt too much. There is a provision in the tax blueprint that calls for limiting “deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of EBIT after that.”

Per the article, many small-cap stocks are debt-reliant for their survival and lack cash, particularly the biotechs. Plus, interests should perk up next year given the Fed policy tightening and Trump bump. The double whammy of reduced interest deductibility and higher bond yields may actually weigh on small-cap stocks (read: ETFs to Bet on the Final Tax Bill: What Hot, What's Not).

Secondly, the reform proposal does not bode well for low-income families. As per an article published on nytimes.com, “low-income families who claim the earned-income tax credit will lose out on at least $19 billion over the coming decade under the bill because of the change in the way inflation is calculated.” Such threats to low-income family could lead to lower outlays on day-to-day life.  

Investors should note that lawmakers made the tax deductions for individuals and families temporary, expiring at the end of 2025 to remain under the $1.5 trillion limit for new deficits. This is yet another blow to households and small-caps may be at the receiving end of it.  However, corporate tax cuts will last.

ETF Plays: What’s Hot & What’s Not

In such a scenario, investors should be choosy while picking small-cap ETFs as a tax-reform play. If we go by the street.com article, small-cap biotech ETFs like Virtus LifeSci Biotech Clinical Trials ETF (BBC - Free Report) should be avoided as the fund is mainly focused on small-cap stocks (read: Value Biotech ETFs to Buy Now).

On the other hand, small-cap cash rich companies should be great picks. Pacer US Small Cap Cash Cows 100 ETF (CALF - Free Report) appears to be a good bet as the fund provides exposure to small-capitalization U.S. companies with high free cash flow yields.

Investors may also keep more faith on mid-cap ETFs as the capitalization offers the best of both worlds – small and large. Mid-cap stocks have moderate domestic exposure and are more sound than small caps. Some of the good mid-cap picks are SPDR S&P 400 Mid Cap Growth ETF (MDYG - Free Report) , Vanguard S&P Mid-Cap 400 Growth ETF (IVOG - Free Report) and Guggenheim S&P MidCap 400 Pure Growth ETF (RFG - Free Report) (read: Time to Buy Mid-Cap ETFs?).

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