We expect the U.S. House and Senate to agree on a tax bill, likely before the end of the year, but if not by the end of the first quarter of next year, when politicians will go into full campaigning mode for the midterm elections in 2018.
There are no guarantees, but we see the Republican Party as galvanized to agree on a tax bill so that Republican politicians can claim a victory before next year’s ballot.
Beware of trading short-term gain for long-term pain
There may be a short-term bump to U.S. GDP growth off the back of the tax bill as it currently stands, but we believe the bill is unlikely to sustainably boost potential GDP growth through improved productivity or an increase in the labor supply.
The Trump administration has been right to argue that the United States badly needs tax reform. It’s also right to argue that, whereas the focus for the past two tax cuts has been on income taxes, this tax bill should focus on corporate tax changes. A final tax bill has yet to be agreed and may look different from what’s currently on the table. Given how the proposals for this tax bill seem to be structured and—more important—funded, we don’t think this tax bill will fundamentally improve the U.S. economy beyond its current potential GDP growth rate of around 2%.
The Trump tax plan may cut the corporate rate to just over 20% in order to benefit old capital—capital that has already been deployed. However, we believe a more effective way to boost GDP growth is to support new capital with expensing or with accelerating depreciation. This would encourage capital expenditure and therefore would boost productivity growth, one way to increase U.S. potential GDP growth.
There’s an expensing clause in the House and Senate versions of the tax bill, but it’s tied to a sunset provision after five years.1 Given that corporations make their big-ticket capital deployment decisions on a much longer timeline than five years, we don’t expect this measure to significantly boost investment.
Some analysts have argued that capital expenditure will rise and U.S. jobs will be created as taxation moves to a territorial system and profits are repatriated back to the United States. According to Bank of America Merrill Lynch’s July 2017 corporate risk management survey, most companies indicated they would use repatriated profits to deleverage, or pay down debt; the next most common answer was to engage in share buybacks, followed by merger-and-acquisition activity, and the fourth most common answer was to engage in capital expenditure, or capex.
Rather than a boost to capex, most repatriated profits would probably be used for deleveraging and more share buybacks, which would likely be positive for both bond and stock markets. However, the survey suggests repatriation would enable job creation if, and only if, companies had been unable to hire because they didn’t have access to funding in the capital markets. The sheer volume of corporate debt issuance in the United States over the past year alone would suggest this hasn’t been the case.
If the proposed tax bill doesn’t shift potential GDP growth by boosting productivity, it could still do so either by increasing labor supply or by redistributing wealth from the top parts of society to the middle and lower echelons. Unfortunately, we don’t see much in this tax bill that could achieve either.
Uncertainties embedded in the Trump tax plan may come back to haunt it
Instead, the proposed tax bill could introduce uncertainty for U.S. corporations, for U.S. individuals—and, by extension, for anyone else seeking to do business with them—in at least three ways:
- Several measures in the bill will have to sunset, so there will be uncertainty about which measures will last and for how long.
- This tax bill has been assembled and will likely be passed with unprecedented haste, and without bipartisan support; there have been no hearings on this bill and the Senate version was passed with amendments scribbled in the margins.2 It’s possible the Democrats could choose to repeal part of the tax bill if and when they regain control of some parts of the government.
- Most important, this tax bill will increase the national debt burden. Not only will this be a drag on growth in the medium to long term—the Joint Committee on Taxation expects the bill will increase deficits by around $1 trillion over 10 years3—but measures will have to be taken to address this, including a possible tax hike.
In the meantime, implications for investors hang in the balance.
1 “Fifteen Provisions to Watch in the Tax Reform Proposals,” National Law Review, 11/17/17.
2 “Senate passes tax bill in massive step forward—here’s how it all went down,” Business Insider, 12/2/17.
3 Macroeconomic Analysis of the “Tax Cut and Jobs Act,” Joint Committee on Taxation, 11/16/17.