Orlando's Outlook: Let's make a deal


Bottom line In light of President Trump’s nightmarish “Groundhog Day”-like performance on fixing health care so far this year, in which the Republican-led Congress has failed repeatedly to repeal the Affordable Care Act (ACA) and replace it with a more economically sound plan, Republicans are starved for a legislative victory ahead of the midterm elections in November 2018. Their pivot to tax reform this week marks a welcomed return to a strong bread-and-butter issue for them, on which many of them were elected. However, given the Democrats’ well-documented intransigence, seeking to strategically resist all of Trump’s legislative initiatives (see Orlando’s Outlook: “Just Say No” of June 14, 2017), Trump is leaving nothing to chance. He has recently begun reaching out across the aisle in an effort to achieve some bipartisan compromise. We think tax reform will follow this more recent blueprint, as Trump’s opening tax salvo last Wednesday will likely be subject to the usual political horse trading in Washington’s smoke-filled back rooms.

Trump optimism has shrunk In the positive afterglow of Trump’s well-received State of the Union address to Congress and the nation in late February, our research friends at Absolute Strategy Research (ASR) estimated there was an 80% chance tax reform would happen by the end of 2017. Washington has put the “fun” in dysfunction over the past seven months, however, sharply reducing ASR’s odds to only 30% more recently. But we here at Federated have remained steadfast in that minority, recognizing that tax reform could very well still happen, due to the Republican party’s need for political self-preservation in next year’s midterms.

From a timing standpoint, we believe that this admittedly ambitious legislation could be drafted by the end of this year and passed by Congress during the first quarter of 2018. But it can’t happen much beyond that time frame and still have a positive impact on the economy ahead of the midterms. Using fiscal policy to boost a $19.25 trillion U.S. economy is akin to turning a battleship in the ocean rather than flipping on a light switch. It takes at least two or three quarters to begin to see stronger economic growth.

Animal spirits already kicking in Yesterday morning, the Department of Commerce raised final second-quarter GDP growth to 3.1%, its strongest reading since the first quarter of 2015 (3.2%). That compares with an anemic 1.2% GDP growth rate in this year’s first quarter, 1.5% for all of 2016 and only 2.2% from June 2009 (when the Great Recession ended) through December 2016, marking the weakest period of economic growth in the post-war era. That data collectively suggests that economic growth clearly was decelerating over the past two years—perhaps back toward a double-dip recession—but that business and consumer sentiment has perked up noticeably since the November 2016 election. So consummating the structural fiscal policy reforms embedded in Trump’s tax proposals now could help to ensure a directional continuation of this more robust pace of economic growth.

Let the debates begin Wednesday’s tax-reform framework was crafted by the so-called “Big Six” in Washington:

  • Steve Mnuchin, Trump’s Treasury secretary
  • Gary Cohn, Trump’s chairman of the National Economic Council (NEC)
  • Paul Ryan (R-WI), speaker of the House of Representatives
  • Mitch McConnell (R-KY), Senate majority leader
  • Kevin Brady (R-TX), chairman of the House Ways & Means committee
  • Orrin Hatch (R-UT), chairman of the Senate Finance committee

Here are some of the key proposals we believe may be open to discussion:

Corporate tax rates The U.S. has the highest corporate tax rate in the world with a statutory 39% rate, compared with the global corporate average of 22.5% among the 35 countries that comprise the Organization for Economic Co-operation & Development (OECD), with Ireland at the low end of that spectrum at 12.5%. This has been an economic albatross for us over the past quarter century as companies and jobs have fled the U.S. to seek lower tax rates elsewhere in a global economy.

Trump has repeatedly mentioned an aspirational cut in the federal rate to perhaps 15%, but we’ve long felt that rate was too low, leaving too much potential tax revenue on the table. We did, however, believe that it was an initial bargaining chip, hoping to arrive at a 20-25% rate, which would definitively resolve the inversion problem. In fact, a competitive 20-25% rate here might actually attract foreign companies to domicile in the U.S. So Trump’s surprising 20% initial proposal on Wednesday might have wiggle room to perhaps somewhere between 22.5% and 25%. By eliminating loopholes and broadening the tax-paying corporate base, we might actually generate more revenue from corporations in a growing economy, which now stands at a paltry 2% of all tax revenue received.

Eliminate state & local tax deductibility To simplify the tax code and help pay for the tax cuts, Trump has proposed eliminating the deductibility of state and local taxes, which could raise an estimated $1.25 trillion over a decade. That enormous howl we’re hearing is from high-tax blue states who benefit from this deduction, such as California, New York, Illinois, New Jersey, Connecticut, Massachusetts and Maryland. This could be a tactical ploy to engage Democrats to join the negotiations. It’s better to be at the table than on the menu.

Simplify and reduce taxes for the working poor and the middle class Collapse seven tax brackets down to three (12%, 25% and 35%), and double the standard deduction for individuals to $12,000 and for married couples to $24,000, while eliminating the $4,050 personal exemption to help pay for it. So the current 10% bracket for the working poor – those earning $25,000 or less – would go to zero. As a bargaining chip, Trump may keep the current top rate of 39.5% as a new fourth bracket for the rich, with an income level to be determined, starting perhaps somewhere between $500,000 to $5 million, according to Cohn.

Estate tax Trump is proposing to eliminate the so-called 40% death tax on estates greater than the individual exemption of $5.5 million, or $11 million for married couples. While it could cost some $644 billion over a decade, Republicans are trying to protect illiquid family farms and businesses from being closed to pay the estate tax upon the founder’s death. A possible compromise is to exempt the family farms and businesses, but to keep the estate tax in place for the liquid investment assets of rich people (think Warren Buffett, Bill Gates and Jeff Bezos).

Repatriation of corporate foreign cash There’s $2.6 trillion in cash sitting on the balance sheets of U.S.-based companies operating in foreign countries. While companies want to bring this cash home to spend and invest, they won’t do it at our current statutory rate of 39%. Trump is proposing a deemed repatriation tax, but he is open to negotiation on the rate. We suggest 10%, which will raise approximately $260 billion, an amount we would lever up and earmark for $1 trillion in much-needed infrastructure spending in the U.S., which will help to boost productivity.

That will leave $2.3 trillion in cash that companies can bring home to repurchase shares and increase dividend payments, to expand research & development and merger & acquisition activity, to fund increased hiring and higher wages to attract and retain quality employees, and to grow much-needed capital investment. This collectively will boost economic growth and financial-market performance.

Corporate capex Since 2011, companies largely stopped investing in themselves, perhaps frustrated with a less-than-business-friendly tone out of Washington. To help reverse that negative mindset, Trump is proposing the immediate expensing of new equipment (but not buildings) for the next five years. In conjunction with a 20% corporate tax rate and repatriation, we think his proposal will help to spur a powerful capex boom that will lift economic growth. To help pay for that, Trump also is proposing to eliminate the corporate interest expense deduction. But this proposal also is open to negotiation. Will existing debt be grandfathered, or perhaps capped at some lower level? Will we go cold turkey, or will this be phased in slowly over some period of time?

Philanthropy and housing In an effort to clean up the personal tax code and broaden the base of higher-wage people paying taxes, we believe that Trump will strive to eliminate virtually every deduction except for charity and mortgage interest. In 2014, the top 1% of America (those making at least $466,000 annually) donated $77 billion to charity, which was 37% of the total charitable contribution deductions. We believe this deduction will remain in place. Continuing the mortgage deduction, on the other hand, will cost about $1 trillion over a decade. But if Trump negotiates to lower the cap on mortgage deductions from $1 million annually now to $500,000, that would raise $300 billion over a decade, all from high-end taxpayers.

How do we pay for this? Republicans calculate that all of this will add about $1.5 trillion to the deficits and federal debt (which already doubled to $20 trillion over the past eight years) over the next decade, which they believe will pay for itself through stronger economic growth. To understand how this might be possible, we need to consider several points:

  • Permanent versus temporary tax cuts Businesses and consumers do not spend or invest temporary tax cuts, they largely pay off existing bills and save them because they know the largesse won’t last. That’s why the Bush and Obama temporary cuts did not really work. But the Kennedy and Reagan tax cuts were permanent, which forced taxpayers to change their behavior, sparking a powerful and sustainable surge in economic growth.
  • Dynamic scoring versus static analysis Democrats tend to employ a Keynesian mindset called static analysis, that if we reduce tax rates, then we realize a reduction in tax revenues, which must be offset or paid for with a reduction in spending. Republicans tend to embrace a supply-side approach to budgeting known as dynamic scoring. This approach calculates the stronger economic growth that ensues when businesses and consumers take their permanent tax cuts and increase spending and investment.
  • How much additional revenue might we expect? Douglas Holtz-Aiken, the retired head of the Congressional Budget Office (CBO) under President George W. Bush, explained to us some years ago that for every 1% increase in GDP (say, from 2% GDP growth to 3%) in a $19 trillion economy such as the U.S., we can add nearly $300 billion in additional federal tax revenues annually, or about $2.7 trillion over a decade. So a thoughtful, balanced reduction in tax rates, which results in stronger economic growth, has the potential to pay for itself.

Is the Fed chair Trump’s ultimate bargaining chip? We believe that President Trump is clearly frustrated with the dysfunction in Washington, the lack of legislative progress on his key fiscal-policy initiatives to date and his low approval ratings. Anxious to break that logjam and get some wins on the board before the midterms, President Trump reached across the aisle this summer to the Democratic Congressional leadership in an effort to broker a bipartisan deal on the debt ceiling. Could he do so again, using Janet Yellen’s expiring term as chair, Stan Fischer’s premature retirement as vice chair and three other open seats on the Fed as possible bargaining chips?

If so, might Senate minority leader Chuck Schumer, House minority leader Nancy Pelosi and the Democrats in Congress be more receptive to supporting some low-hanging legislative fruit on which both parties already agree in principle, such as corporate tax reform, repatriation and infrastructure spending? In the art of the deal, Trump could negotiate some much-needed political leverage to get important fiscal-policy reforms passed in Congress, which would likely boost economic and corporate earnings growth and share prices.

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