by Elliott Morss, Morss Global Finance
Introduction
Tax reform is never easy. There are with lobbying groups aligned on all sides to protect their special interests and create new ones. This makes tax reform one of the most difficult political feats to accomplish. At this point, only the broad outlines of Trump’s tax reform plan are available. Below, the numbers on what is known are presented. There appear to be some problems.
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The President’s Budget
The Congressional Budget Office (CBO) has examined the President’s 2018 budget.
It concludes:
“Excluding economic feedback effects, CBO…estimates federal budget deficits under the President’s proposals would shrink relative to the size of the economy over the coming decade, ranging between 2.6 percent and 3.3 percent of gross domestic product (GDP) during that period.”
Table 1 provides the CBO data. The trajectory here is positive as measured by the deficit as a percent of GDP because the projected deficit is growing at a slower rate than GDP.
Table 1. – The President’s 2018 Budget Proposal (bil. US$)
Source: CBO
Revenue Adjustments
But the devil is in the details. Consider first what has happened to revenues projections since the budget was presented last May. Since then, efforts to repeal the Affordable Care Act have failed. That failure means the projected savings of $1 trillion over the next decade have been lost. Needless to say, that $1 trillion was a critical component in planning the Trump tax cut.
Table 2. – Revenue Adjustments (bil. US$)
Source: CBO
Expenditure Adjustments
The President’s budget proposal included a number of dramatic cuts in discretionary items (Table 3). It is highly unlikely that Congress will approve many of those highlighted.
Table 3. – Proposed Expenditure Changes (bil. US$)
Source: CBO
Overall, I assume that as a result of Congressional pressure, $30 billion of the proposed $72 billion proposed expenditure cuts will be restored. In addition, $50 billion in disaster relief will probably be added during the 2018 fiscal year. And in light of projections of more severe storms in coming years, I have added $10 billion in each of the following years.
Table 4. – Expenditure Adjustments (bil. US$)
Source: CBO
Table 5 incorporates the revenue and expenditure adjustments into the President’s budget. Not surprisingly, the budget deficits as a percent of GDP grow.
Table 5. – President’s Budget w/Adjustments (bil. US$)
Source: CBO
As one might expect, the adjustments cut significantly into the deficit performance. Instead of falling as a percent of GDP, the deficit share remains the same throughout the period.
The Trump Tax Plan
According to news reports, members of the Senate Budget Committee have agreed on a budget that would allow for a $1.5 trillion tax cut ($150 billion annually) over 10 years. Studies of similar plans produced by Mr. Trump and House Republicans have been projected to cost $3 trillion ($300 billion annually) to $7 trillion (700 billion annually) over a decade.
Table 6 shows the numbers assuming a $2 trillion tax cut over the next decade. The debt increase is substantial. Under the original Trump budget, the cumulated deficits over the next decade totaled $6.8 trillion. With the budget adjustments and a $2 trillion tax cut, the cumulated deficits grew to $10.2 trillion. Is there a point where reckless US government deficit management curtails the demand for US debt? Certainly, a tax cut causing the Federal government debt to increase by half will be a pretty good test of this question.
Table 6. – Effects of $2 Trillion Tax Cut Over Next Decade (bil. US$)
Source: CBO
Economic Analysis
Many Republicans argue that economic growth will compensate for lost revenue. For example, Senator Patrick J. Toomey, a Pennsylvania Republican who sits on the Finance Committee, said he was confident that a growing economy would pay for the tax cuts. This claim is not new. For some time, Laffer et al have been claiming that tax cuts will be made up for by higher tax revenues generated by a growing economy.
There is no question that at times of high unemployment, deficit finance will generate economic growth and lower unemployment. In fact, almost all economists argued for more deficit finance to get the US/world out of the global recession/depression resulting from the US banking collapse in 2008. But today is quite different. With the unemployment rate at 4.3%, the US is effectively at full employment/full capacity utilization. And in these circumstances, increasing the deficit normally results in inflation.
But there is dissatisfaction with US employment. Why? People are upset that their wages are lower than in the past. And why is this? It has little to do with jobs lost overseas. It is primarily the result of labor saving automation. And in these circumstances, one can be assured that a significant portion of the tax cuts to business will be invested in more labor saving technology. In short, tax cuts could have the perverse effect of reducing employment and lower wages.
Investment Implications
Treasury Secretary Mnuchin has warned:
“There is no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform done…. To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done you’re going to see a reversal of a significant amount of these gains.”
But what if it gets done with the sort of increases in deficits suggested above?
US markets are already high. A clean tax reform bill that pleases “most” is not likely. I there will be a significant market sell-off whatever happens. In such circumstances, an argument can be made for high dividend investments with low payout ratios. It is also time to consider emerging market equities.
