Investment Insights: Jury-rigged tax cuts

Wade Balliet
Posted by Wade Balliet
Investment Strategy

This weekly report presents insights from our Global Investment Management team.

Mechanical gear wheels, the center one has "tax reform" engraved on it.Republican legislators are on the verge of a major win after repeated failures in attempting to pass meaningful changes in policy. In the wee hours of Saturday morning, the Senate narrowly passed its tax bill in a 51-to-49 vote, which was along party lines with the exception of Republican Senator Bob Corker.

While both the House and the Senate have now passed the bill, known as the Tax Cuts and Jobs Act, each chamber has their own version of the proposed tax cuts and amendments. Each form has some of the same general adjustments to tax policy, but include key differences such as four versus seven individual tax brackets, a corporate alternative minimum tax, mortgage interest deductions, a potential doubling and eventual elimination of the estate tax exemption, and even modifications to health insurance and Medicare in the Senate version. Markets initially opened higher on the news with the S&P 500 Index reaching a fresh all-time high of 2,664 on Monday in intraday trading before declining. Yields on the benchmark 10-year Treasury followed a similar pattern, declining after an initial increase.

Investors continue to be unimpressed by the current shape of tax overhaul – and for good reason. In response to the S&P 500 declining the day of the announcement, The Global Investment Management team believes that some form of tax cuts was already priced into the market and the new plan leaves more to be desired. The proposed corporate tax cut from 35% to 20% supposedly would trickle down to an increase in capital investment and wage growth. However, cuts for individuals would result in only temporary benefits. According to the Committee for a Responsible Federal Budget, a non-profit organization, businesses could receive $1.1 trillion in tax benefits, while individuals would receive $200 billion in net tax benefits. Of individuals, the top 5 percentile of earners would receive the largest benefit, based on a report from the Tax Policy Center, which goes on to state, “Compared to current law, 9% of taxpayers would pay more in 2019, 12% in 2025, and 50% in 2027.” Individual tax cuts may not only disappear but could become tax increases after a decade for half of American earners.

That’s right – some of these tax cuts could be limited to just 10 years. In order to meet their self-imposed year-end deadline on tax reform, Congress employed a budgetary loophole called reconciliation, which allows a simple majority to pass bills as long as the legislation has to do with the federal budget and if the bill meets certain criteria limited under the Byrd Rule. This permitted Republicans to pass laws essentially without any Democrat support, but at the cost of restrictions to their changes including a 10-year sunset clause, which will likely remove any individual tax cuts by 2027.

Despite some apparent shortcomings of the bill, the goal of reducing tax burden to increase growth may end up working out – at least temporarily. Under the new plan, estimates from the Joint Committee on Taxation show a 0.8% increase in GDP, 0.6% higher employment, and 0.6% higher consumption over the 10-year period. However, the national debt would increase by an estimated $1.4 trillion on top of the $10 trillion increase in the baseline forecast. While we view the tax cuts as a net positive over the near-term, particularly for corporations, we believe it is important to remember that consumer spending is the largest component of U.S. growth. Relieving the tax burden for businesses may help to bolster profits and GDP above its current trend, but consumers remain the deciding factor for growth domestically.

Chart showing various market returns as of 12/5/17
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