Since the election markets have focused on the pro-growth fiscal and regulatory aspects of President Trump’s policy agenda, and have been largely immune (bemused?) by much of the news (noise?) being tweeted (or is it twittered?) out of Washington (or is it Manhattan?).
The rubber is about to hit the road on President Trump’s pro-growth agenda, particularly on tax. President Trump intimated a few days ago that he was just 2-3 weeks away from releasing the details of what he has labelled a “phenomenal” tax plan. Therein lies the first risk – overpromising and underdelivering.
We have a few hints on what “phenomenal” might look like. The President made various commitments to tax reform on the campaign trail and we also have the 2016 Congressional Republican ‘blueprint’ on tax reform, authored by House Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady.
On personal income tax both the President and the Republican Party (GOP) proposal called for a reduction in individual income tax rates while at the same time eliminating some deductions. Both proposals would collapse the current seven income brackets down to three which would reduce the marginal tax rate for many taxpayers. The largest tax cuts in percentage terms would come at the top end of the income distribution.
However, Congressional republicans are primarily focused on corporate tax reform, with a particular intent on lowering the tax rate on business investment and reducing the incentive for US companies to locate production overseas.
Latest Organisation for Economic Co-operation and Development (OECD) corporate tax data indicated that total US profits are taxed at 39.9% at the headline level, which includes both federal (35%) and state and local taxes. Average OECD taxes are lower, at 24.7%, in 2016. In reality, the effective rate of tax paid by companies tends to be lower because of business write-offs and allowances, with estimates suggesting an effective tax rate of 25% for the S&P 500.
Corporate tax reform is a key “to do” item on the agenda for President Trump and for the Republican Party. The key items that have been discussed include:
- A cut to the Federal corporate tax rate (currently at 35%). The GOP proposal suggested a 20% tax rate and Trump is now suggesting a tax rate “between 15% to 20%”.
- Introducing immediate write-off of capital investments, rather than capitalising and depreciating these investments over time.
- A change in net interest expense deductibility to equalise treatment of debt and equity financing.
- Cutting the taxation of US offshore earnings brought back onshore and introducing a one-time transition tax of “up to 10%” on these repatriated funds, payable over a number of years.
- A border tax adjustment, which is an additional tax on importers and (ultimately) a tax rebate to exporters, to encourage domestic production.
A cut to the statutory corporate tax rate seems to have strong support and is likely to pass, though we think the border tax adjustment will be more controversial and harder to get through. A simple majority is all that is required to pass tax and spending reforms, though measures outside the budget require the support of 60 out of 100 in the Senate to approve.
The devil will of course be in the detail. Critical for us in determining the tax plan’s “phenomenalness” will be:
- the extent to which the tax plan simply delivers tax cuts or whether we see genuine productivity-enhancing tax reform.
- the degree of fiscal stimulus delivered and the implications for the US Federal Reserve (the Fed). Any fiscal stimulus is coming at a time when the economy is already at or very close to full-employment and the central bank is already tightening monetary policy.
- the impact the tax changes have on the structural budget balance and long-term fiscal sustainability (ie debt ratios). When Ronald Reagan took office public debt was 30% of GDP. It is now over 100% and already on a deteriorating trajectory, largely thanks to demographics.
- the extent to which personal tax cuts, alongside whatever changes may occur to things like deductibility of state and local taxes and various other deductions, increases or reduces inequality.
- the extent to which perceived tax problems are fixed (high and uncompetitive statutory corporate tax rate), only to be replaced by new ones (the opening up of a bigger gap between the top personal tax rate and the corporate tax rate, encouraging people to change their tax status from an employee to a sole trader).
There are many moving parts and there will be lots to think about when the detail emerges. Critical for us, the tax package is coming at a time when we are expecting to see a cyclical boost to business investment around the world, but particularly in economies like the US that are closest to full employment.
Corporate tax reform is one tool to lift business investment. However, tax cuts may not be enough by themselves to lift business investment. Other factors will likely be required for stronger investment:
- Better corporate earnings. Earnings growth and earnings expectations are lifting, at least in the US and in Australia, which is a positive sign that the nominal income recession is over. Rising inflation tends to be a good sign for corporate earnings.
- Lower business hurdle rates which haven’t dropped by as much as expected, given the low level of interest rates.
- Better confidence about the economy, with businesses normally citing better consumer spending as a sign of better future growth prospects.
Also, additional earnings could be distributed through dividends, as shareholders have become accustomed to higher dividend payouts over recent years. Another point to keep in mind is that business investment in the advanced economies may be stuck in a structurally lower level for a while because of the increased significance of the service sectors. Service sectors tend to require less investment, compared to the traditional industrial sectors of an economy.
Right here, right now markets have priced in an expectation that US corporate tax reform will be positive for US growth and will lift inflation. Anything less than “phenomenal” is likely to be detrimental to equity markets and growth expectations.
Thanks to Diana Mousina in our Sydney office for her contribution to this note.
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