The late Arthur Godfrey, a radio and television broadcaster, once joked: "I'm proud to pay taxes in the United States. The only thing is, I could be just as proud for half the money."
Godfrey's wish is not fully in the offing, but his fellow sympathizers recognize that the current political backdrop may be the best chance in years to meaningfully reduce corporate and income tax rates. Long-term and sizable tax cuts, financed with deficits, could serve to augment U.S. growth, boost corporate earnings, and provide cover for the Federal Reserve (Fed) to continue raising interest rates in the year ahead.
Alas, passing a tax bill through the U.S. Congress may be easier said than done. The good news for investors is that the U.S. equity market has been skeptical of the bill's passage for much of 2017.
Though still short on all details, the tax plan proposed by the Republicans would result in roughly $5 trillion in tax cuts over the next 10 years, including:
- a reduction in the corporate tax rate from 35% to 20%;
- a decline in the pass-through rate from 39.6% to 25%;
- 5 years in which businesses will be able to fully expense their capital purchases
- a move to a territorial system (i.e., minimal or no U.S. taxes upon repatriation of foreign earnings);
- a reduction of tax rates for individuals in the top bracket—from 39.6% to 35%; and
- the elimination of the estate tax.
Here's the rub. Under budget-reconciliation rules, a new tax bill cannot increase the long-term deficit beyond a predetermined level, which is currently expected to be $1.5 trillion. Dynamic scoring, which assumes that higher growth from tax cuts leads to increased tax revenue, will not be taken into account by the Congressional rules process. That means that the Republicans in Congress need roughly $3.5 trillion in offsets to complete tax reform, unless they reduce the amount by which they cut the corporate and income tax rates.
It is possible but it will not be easy. Consider, for example, that the initial framework calls for all individual itemized deductions to be eliminated (with the exception of those allowed for charitable contributions and mortgage interest. It is estimated that such a move would help raise $1.5 trillion in revenue over the next 10 years, bringing the Republican Party close to 40% of the offsets required. However, the House is already retreating from a move to eliminate the state and local deductions for those who itemize their returns. In addition, President Trump has also dispelled reports that the tax plan would be paid for in part by a cap on the amount of money that can be placed in tax-deferred 401(k) plans.
In short, tax reform is hard—and you can be sure there is intense lobbying activity on Capitol Hill to preserve every constituency’s favorite deductions. Even if the math ultimately works, it is unclear that 50 Republican Senators (Vice President Mike Pence would cast the deciding vote) would vote for the bill. The Alabama Senate race could loom large if Republican Roy Moore fails to hold the seat for the Grand Old Party (GOP).
Many investors we talk to express their concern that the market has already priced in the tax cuts and is now poised to be disappointed. They question the new highs the market has reached.
The short answer is that the market is reaching new highs because the global economy is experiencing synchronized expansion for the first time since the financial crisis, monetary policy remains accommodative in most of the world, and stocks continue to trade cheap relative to bonds globally.
In our view, the market’s highs likely have little to do with potential tax cuts. For example, consider the leading market performers: In the aftermath of the 2016 U.S. Presidential election, the big winners were U.S. dollar assets (as a result of expectations of stronger U.S. growth); small-cap stocks (since smaller companies typically pay higher effective tax rates and stand to benefit more from a potential tax cut); and value stocks, in keeping with the view that, in a world where there is little growth, buy growth; if growth is ubiquitous, buy value (Exhibit 1).
That trend lasted until the end of 2016. And a funny thing happened on the way to the all-time highs the market has reached today: Market leadership has flipped on its head.
Since the beginning of 2017 (with the exception of a few recent weeks), the outperformers have been non-dollar assets, large caps and growth stocks—the exact opposite of the so-called Trump trade. In fact, small-cap stocks are still trading cheap relative to large-cap stocks, and value stocks are as cheap relative to growth stocks as they have been in years. Even the Industrial sector, which likely stands to benefit from accelerated capital depreciation, is among the U.S. sectors trading at a discount relative to its historical average. Had these fiscal policy-sensitive market segments been pricing in tax cuts, this would not have been the case (Exhibit 2).
We'll leave the handicapping to the Washington insiders, but will proceed as if nothing has meaningfully changed for the time being. If we get sizable deficit-financed tax cuts, then we would change our minds and expect market leadership to resemble the immediate aftermath of post-2016 election.
If a tax bill fails to pass, we foresee a backdrop of modest global growth and benign inflation. Even more likely, we anticipate the market leadership of 2017 (which consisted of international equities—including those of emerging markets—as well as U.S. growth stocks) carrying over into 2018. Ultimately, it's a growth environment the current political leadership will not like (and may pay for in the mid-term elections). But fortunately, it should prove just fine for corporate earnings while not bringing forth higher inflation and the significant policy tightening that ultimately ends cycles.
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