Highlights

• As part of “the largest tax cut in history” the Trump Administration is proposing to lower the corporate tax rate to 15% while shifting to a territorial system in which U.S. companies no longer would be disadvantaged on taxation of overseas profits.  The stated goal is to boost long-term economic growth through increased business capital spending.
• The one page proposal, however, is really a wish list of tax cuts for corporations and individuals, rather than a plan to reform the tax code.  That is the goal of the bill Paul Ryan and House Republicans drafted last summer; however, prospects for its passage have been hurt by failure to repeal Obamacare.
• While equity investors are banking on corporate tax cuts to be enacted later this year, the unanswered question is how they will be paid. The President and his supporters contend the proposal pays for itself with stronger growth.  However, the risk is the federal deficit will blow out from already high levels.

The Trump Administration’s Wish List

Throughout the 2016 campaign, Donald Trump advocated lower taxes for businesses and individuals as a way to bolster economic growth, and he called for the corporate tax rate to be lowered to 15% from the current rate of 35%.  Because there were few details to back this proposal, however, investors focused on the tax bill drafted by Speaker Ryan and the Republican House leadership, as it had broad support among the Republican rank and file.  It contained four key provisions: (i) reduce the corporate tax rate to 20%; (ii) allow immediate expensing of capital outlays, but exclude interest deductions; (iii) incent businesses to repatriate profits earned abroad; and (iv) implement a border-adjustment-tax (BAT) that would effectively subsidize exports and tax imports.

The intent of the Republican bill was to streamline the tax code and facilitate passage by making it deficit neutral.  With the first three provisions generally consistent with the President’s agenda, market participants focused on the BAT provision that is controversial because of the adverse consequences for firms that rely on imports.

In the wake of the health care fiasco, the prospects for a tax bill that is deficit neutral were dealt two major blows: (1) The failure to replace Obamacare meant the Republican leadership could not garner the projected savings in revenues of more than one trillion dollars over ten years that would have occurred if Medicaid expansion had been halted.  (2) The wrangling over health care made it less likely that the BAT provision would clear the tax bill, because it is too complex and too controversial.

As these developments unfolded, I envisioned a situation in which Speaker Ryan would tell the President that he could no longer support a 20% corporate tax rate unless additional revenues were forthcoming.  Instead, the President upped the ante on Speaker Ryan and the Republican leaders in Congress this past week by stating he favored a 15% corporate tax rate and that he was not concerned about the budgetary consequences. (According to the Urban-Brookings Tax Center, lowering the corporate tax rate to 15% could entail a revenue loss of $2.4 trillion over 10 years, or $600 billion more with a 20% tax rate.)  In addition, the Administration’s proposal appears to drop the BAT provision, which is estimated to generate more than $1 trillion in revenues over the next ten years, and is silent on the issue of deductibility of interest expense.

In the Trump Administration’s view, a lower tax rate would spur stronger economic growth, which would boost tax revenues.  The problem, however, is that tax cuts may provide a boost to the economy by increasing aggregate demand, but the effects are likely to be only temporary if they blow out the budget.

Do Budget Deficits Matter?

This issue loomed large during the 1980s when the Reagan Administration achieved significant tax cuts for businesses and individuals that helped boost the economy.  Although they were accompanied by a significant expansion in the budget deficit, interest rates plummeted from record levels, mainly because the Federal Reserve succeeded in reining in inflation and inflation expectations.  Accordingly, many people at the time concluded budget deficits did not matter for the economy or financial markets.

One needs to be careful about drawing this inference today, however, because the economic environment is very different.  First, inflation and interest rates are near record low levels, and they are likely headed higher as the economy improves and the Fed normalizes interest rates.  Second, the trend rate of economic growth has fallen from more than 3% per annum to about 2% p.a. in the past decade. The challenge the Administration and Congress face is that it is not easy to boost productivity growth and increase labor force participation.

According to the Congressional Budget Office (CBO) projections based on recent trend growth, the budgetary picture is about to worsen in the absence of any policy changes: The federal deficit is projected to grow from less than 3% of GDP to more than 5% by 2027.  This is mainly due to increased outlays for entitlement programs such as Social Security, Medicare and Medicaid owing to the aging of the population and medical costs that have outstripped the pace of inflation.  Stated another way, ten years from now all federal revenues would go to pay for entitlements and debt servicing costs, meaning that all discretionary programs would have to be covered out of deficit financing.

Supporters of lower tax rates counter the picture is far less bleak if trend growth of 3% is restored. (See the commentary by Stephen Moore “Growth Can Solve the Debt Problem” in the Wall Street Journal dated April 26.)  This line of reasoning, however, is risky, because one can always assume the problem away via optimistic growth rate assumptions.  (See the commentary by former CBO Director, Douglas Holtz-Eakin, “Trump’s Tax Plan is Built on a Fairy Tale” in the Washington Post dated April 26.)

So far, at least, financial markets have adopted a “wait and see” posture.  Equity investors are banking on a boost to the economy and corporate profits from tax cuts being enacted, while the bond market is dubious, but supported by lower interest rates abroad.

Speaker Ryan and Republican leaders in Congress, however, are more concerned about prospects for the budget. They are likely to push back on the President’s tax initiatives, especially when he is also supporting increased spending on defense and infrastructure and no checks on the growth of entitlement programs.  It remains to be seen, therefore, how the political process will play out, and whether the President’s tax proposal or the Congressional Republicans’ will prevail. Meanwhile the process is expected to drag on for a long time and possibly into next year.