Trump's Tax Cut - Effects on the Federal Deficit and US Economy
It is clear that corporate tax has large impacts on a country’s economy. In the UK, corporation tax is the fourth largest contributor to the Exchequer after income tax, National Insurance contributions and VAT[1]. In the US, Trump’s tax reform aims to cut the corporate tax rate ‘from one of the worst to one of the best’ – from 35% to 20%. It is hoped that the reform would boost the US economy by discouraging corporate inversions and providing extra jobs[2].
The Federal Deficit
Major business media such as suggested that corporate inversion will not be reduced as significantly as expected[3]. Corporate inversion is the process by which companies, especially U.S.-based companies, move overseas to reduce the tax burden on income[4]. In reality, companies on average pay around 25% due to the presence of loopholes. Technology companies, for example, are good at avoiding taxes and pay only 23%, according to Deutsche Bank. According to the Congressional Budget Office, the latest version of the House bill would add $1.7 trillion to the federal deficit over 10 years[5]. The Institute for Fiscal Studies also commented that the government’s policy choices will lead to a decline in corporate tax receipts[6] which “marks a break with a long-run trend that shows volatility with the economic cycle but no persistent decline in receipts.” These considerations are not without history. For instance, Obama concluded that there was a reasonable reform path to cutting from 35% to 28% while Mitt Romney’s presidential campaign in 2012 concluded more aggressively that there was a possible plan to cut from 35% to 25% with the risk of losing some revenue. Whether the current tax cut will be too extreme that would render it not passable is now one of the market’s focus.
The Economy
Whether or not a tax cut will generate increased corporate investment in the domestic market is questionable. William Gale from the Brookings Institution pointed out most big firms nowadays don’t have financing problems because cost of borrowing is at record-lows. The real problem appears to be that firms have trouble identifying profitable investment opportunities to justify expanding capacity, recruiting more talent, and upgrading their equipment. In addition, there is a legitimate suspicion that corporations are and will continue to use their profits to buy back their own stock[7], instead of investing in human capital or other financial activities. The Trump tax plan wouldn't do much to address this problem.
The current high-tax regime has not meaningfully deterred investors from investing in the US; therefore, any tax cut represents a margin loss for the government without the offsetting volumes gain in investment. The reduction in Republican tax plan may even indirectly send US capital abroad. Although investment opportunities have become more mobile as globalisation facilitates free cross-border capital flows, many investment opportunities in America, for example in Silicon Valley, are difficult to replicate elsewhere because of factors such as political risks and technology requirements etc. In addition, the House tax bill contains several provisions[8]. The bill specifies that US companies with offshore headquarters would have an opportunity to repatriate an estimated 2.7 trillion at 12% and at 5% tax rate on non-cash amounts which can be paid in equal instalments over 8 years. This might actually encourage investment abroad, divesting to other jurisdiction and economies without benefiting the US as a nation even in financial terms. And if, as is likely, the tax cut is financed by borrowing, it is likely to push up interest rates and the dollar which would create an economic drag especially for companies that heavily rely on overseas operation and exports.
The Future and Potential Investment Opportunities
Recently, Senate Republicans confirmed the vision that the tax-cut plan will be delayed to 2019[9]. There is also rumour[10] about the proposal of reducing the federal corporate tax rate by 3% per year from 2018 to 2022, eventually bringing the rate down to 20% from the current 35%. An analysis[11] from the Tax Policy Centre found that the current unified framework would add $2.4 trillion to the deficit (see chart below).
The dollar and global borrowing costs as reflected in sovereign bond price rose on September 28 after President Trump proposed the biggest tax reform in 30 years followed by strong job report and wage data, which supports another rate hike by the Federal Reserve in its December meeting[12]. In terms of yields, the two-year notes rising to a nine-year high of 1.49%, the 10-year yield rose as far as 2.357% – its highest in more than two months, and the 30-year bond yield climbed to 2.901% – seeing its biggest one-day rise in almost seven months. In terms of the dollar strength, USD/JPY probed above 113 Japan yen per US dollar. However, without the anticipation of the rate hike in December, the tax plan alone merely created a short-term impact on yields[13]. It is obvious that in order to raise more debt for cover the increased expenditure and recover the tax deficit, the government has to issue more debt. Consider the graph below:
Graph 1: CBO Budget Projections with Debt Held by the Public as a Percentage of GDP[14]:
By definition, the lower the demand, the lower the price and hence the bond yields higher. More debt means more UST supply, yet higher supply does not guarantee a higher yield. First, the effect of a bigger budget deficit and more supply on the bond market is not perfectly correlated. Consider the 10-year Treasury yields rose about 50 basis points in the weeks after Trump’s victory in November 2016 and peaked just below 2.65% in February 2017. The tax reform come into play and that higher level of yield is widely regarded as a reasonable short-term target after ending in late September at 2.32%. Second, we have a Federal Reserve that is likely to boost interest rates in a longer timeframe and will soon ridding Treasuries and mortgage securities from its balance sheet. The technology industry, as mentioned above with their tax avoidance, may benefit less[15].
Graph 2: Goldman Sachs’ High (white) / Low (yellow) Tax Rate Stock performance, normalised to 8 November 2016 = 100
In terms of high risk ETFs, iShares Russell 2000 Growth ETF (IWO) is often regarded as one of the ETFs that are set to benefit the most from the tax reform. This is because small companies used to pay huge taxes, which an average of over 30%, in the US and a tax cut could be significant to these companies’ earnings. IWO remained one of the top choices for investors with high risk tolerance as it offers exposure to companies whose earnings are expected to grow at a higher rate when compared to the market’s average. Equally, it can also be argued that the high sensitivity may render IWO to decline more than large-caps if the markets performance and introduction of policies are worse than expected.
Sources:
[1] Office for Budget Responsibility, Economic and fiscal outlook, Cm 9212, March 2016 p111 (Table 4.6).
[2] https://assets.donaldjtrump.com/trump-tax-reform.pdf
[3] https://www.vox.com/policy-and-politics/2017/11/6/16606812/republican-tax-plan-corporate-cut)
[4] https://www.investopedia.com/terms/c/corporateinversion.asp
[5] http://www.reuters.com/article/us-usa-tax/tax-cut-debate-in-u-s-congress-swings-to-senate-bill-idUSKBN1D82QL?feedType=RSS&feedName=newsOne&google_editors_picks=true
[6] Helen Miller & Thomas Pope, The changing composition of UK tax revenues, IFS Briefing Note BN182, April 2016 p2
[7] https://www.newyorker.com/news/john-cassidy/a-white-house-fairy-tale-about-the-trump-tax-plan
[8] https://www.taxreformandtransition.com
[9] “Taxes, taxes, taxes”, Bloomberg, Nov 9
[10] http://uk.businessinsider.com/trump-gop-tax-plan-corporate-rate-2017-10?r=US&IR=T
[11] http://www.taxpolicycenter.org/publications/preliminary-analysis-unified-framework/full
[12] https://www.cnbc.com/2017/09/28/reuters-america-global-markets-trump-tax-plan-sends-dollar-bond-yields-higher.html
[13] https://www.bloomberg.com/view/articles/2017-10-03/trump-tax-plan-is-only-bearish-for-bonds-in-the-short-term
[14] https://www.cbo.gov/sites/default/files/115th-congress-2017-2018/reports/52370-outlook_0.pdf
[15] https://www.ft.com/content/18b1db26-a389-11e7-9e4f-7f5e6a7c98a2