First take on the Trump tax plan
Further light has been shed on US President Donald Trump's much vaunted tax plan, though specific details are still scant. The proposal includes reducing the statutory corporate tax rate from 35% to 15%. The proposal also plans to cut the so-called ‘pass through’ rate, the rate that mostly small firms pay via the individual tax code. A ‘one-off’ repatriation tax of 10% is also proposed. Absent is any suggestion of a border tax.
The disappointment is the lack of detail, but there are likely bigger issues ahead. The first and most critical hurdle is procedural. Under current rules, tax changes can only be passed via the reconciliation process (ie by a simple majority in the senate) if they are revenue neutral after 10 years. Anything else requires 60% approval. The package will need some Democrat support, especially given the President may not be able to rely on support of all of his own party as the shambles around the reform of Obamacare demonstrated.
The Republicans are the party of small government so there are elements in the party who will be concerned about debt levels and fiscal sustainability. Last week the Congressional Budget Office released their latest set of long-term budget projections showing that on a ‘no policy change basis’ the United States is already on track by 2047 to have a budget deficit of 9.8% of GDP and a federal debt to GDP ratio of 150%, up from 77% currently.
In terms of substance, given what we know, the package falls short of what we would call genuine tax reform. The US tax system is complex and compliance is burdensome. Tax reform should have consisted of simplification of the system. Some element of revenue neutrality could have been achieved by a broadening of the tax base in line with the worthy tax policy principle of ‘low rate broad base’. In fact, the lowering of the pass-through rate risks undermining the tax base as individuals may look to set themselves up as contractors.
The package will rely on the tax cuts boosting growth. The problem here is that the economy is already at full-employment and the US Federal Reserve (the Fed) is hiking interest rates. The time for fiscal stimulus is at the bottom of the economic cycle. Tax cuts here simply make the Fed’s inflation containment role harder to achieve. What fiscal policy giveth, monetary policy may taketh away!
Of course, if the corporate tax reductions lead to higher business investment, that will boost productivity and the capacity of the economy to grow without generating inflation. However, tax cuts by themselves, while boosting after tax profits, may not automatically lead to higher investment. That requires other things like confidence in the broader economy and more detail from the administration on other elements of its pro-growth strategy.
Also note that while the statutory corporate rate is 35%, the average effective rate is 24%. So a reduction to 15% is not that big compared the average rate most firms pay now.
On the individual taxation side, the Administration’s proposal envisages cutting down from the current seven income-tax rate gradations to just three, and lowering the top rate for individuals to 35% (from 39.6%). Deductions for home mortgage interest servicing and charitable contributions would remain in place. Finally, in a generous gesture to the wealthier Americans, estate tax would be eliminated.
To sum up, the immediate economic impacts of the Trump tax proposals are a little less than the “phenomenal” billing the President gave them a couple of months ago. All the same, the plan does signal a very business-friendly and opportunistic Federal Government, not unduly concerned about deficits and sustainability. This could help offset investor nerves about the capacity of the new Administration to significantly impact the real economy during its first term. The plan is probably marginally positive for equity investors, while providing yet another reason to be cautious about the prospects for US government bonds over the longer-term.
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