By Mauldin Economics. Originally published at ValueWalk.
I’ve been doing a multipart series on the proposed tax reforms in Thoughts from the Frontline (subscribe here for free).
In part two, I talked about what I like about the Better Way proposal. In part three, I pretty much eviscerated the border adjustment tax (BAT).
I think it has the real potential to create a global recession. You’ll need to read the series to see why, but a lot of it has to do with simple game theory.
Tax Reform
It holds that if you upset the equilibrium, the other partners at the table will change their strategies, too. This is a factor that the measure’s Republican proponents are ignoring.
Below is an analysis of the current tax proposal from my friend Constance Hunter, who is the chief economist at KPMG and wicked brilliant. She tries to be fair but comes up with many of the same negatives that I do (and a few more).
One of the things that Constance notes is that real, forceful change is required to get this reform through Congress. Without Democratic support in the Senate, there will be an automatic sunset provision in 10 years that would be devastating to the economy.
There needs to be a real effort to figure out how to create something bipartisan.
Again, it is not that the current proposal doesn’t have many good features. It is that the bad ones—which actually allow you to pay for the good tax cuts—go about it in the wrong way and create serious problems.
Why is this so important? Because if we don’t come up with a tax proposal that can get through Congress this year, then we’re looking at 2018; and do you really think the stock market is going to levitate, waiting until 2018 for a tax proposal that’s not even on the table yet?
Congress needs to focus clearly and figure out what they’re going to do—and not do things that would make the US and global economic situation even worse.
As investors and portfolio managers, we need to be paying attention to what Congress is saying and doing and figure out how their actions are going to affect the economy and our portfolios.
The right policies and programs could be very good for the markets. The wrong ones? You’d want to get out of the way of that train.
“Trump-O-Nomics” – An exploration of the proposals
By Constance Hunter and Jennifer Dorfman
As Donald J. Trump begins the presidency with promises of greater GDP growth and job creation, this report examines both the cyclical and structural backdrop that could impact the efficacy of his plans. The report will also discuss the border adjustable tax proposal and some possible implications. The analysis takes into account the more than 20 percent of U.S. imports that are priced in dollars, a unique situation that alters the normal currency adjustment assumptions economists make when assessing the impact of such a tax.
It is debatable how much influence presidents can have over near-term, cyclical, economic growth. Certainly expansionary or contractionary fiscal policy has some influence, but in the United States, discretionary government spending is a relatively small percent of GDP so this influence is minimal. Presidents have more influence over structural aspects of GDP via changes to regulation, changes to the tax code, and changes to total government spending and resulting debt levels.
In terms of the cyclical prospects for the UnitedStates, the recovery appears to be in about the 7th inning. The Federal Reserve Bank (the Fed) is hoping its policies can create some overtime innings and a soft landing; however, this is often the hope of central banks, yet few are lucky enough to achieve such feats. The largest constraint to the Fed’s goals is apparent tightness in the U.S. labor market. For example, the National Federation for Independent Business1 reports that the number of respondents who say there are few or no qualified applicants for job openings exceeds the long-term average of 42 percent. This suggests that even if the participation rate rose, the lack of labor market depth would still pose constraints for business expansion despite any new incentives from tax changes or other stimulative measures.
In addition to relatively tight labor supply, the Fed has just raised rates for the second time in the current cycle. Since the election, long-term interest rates have risen more than short-term ones due to anticipation of more frequent rate increases in 2017 and some possible increase in risk premia due to fiscal policy uncertainty. However, we believe the biggest contributor to higher rates is the stronger U.S. economy that was in train before the presidential election. In addition to cyclical momentum seen in jobs and consumption growth, higher oil prices are supporting a return of oil and gas investment. Our base forecast for growth in 2017 is now higher than before the election due to strong growth momentum.
Therefore,Trump enters his presidency at the end of a long, if tepid, expansion with little capacity for faster growth in the near term.
Nevertheless, during the first 100 days, the Trump administration will want to achieve some quick wins. One way to start this would be to streamline regulation. A study from the conservative think tank, Heritage Foundation2 found the cost of new regulations implemented since 2008 amount to an average of $15 billion a year spent on compliance. The argument suggests this is money not spent on generating economic activity and it reduces productivity. Even if this number is off by 50 percent, given that U.S. corporate investment has averaged $130 billion a year since 2010, even $7 billion of extra investment could add up to 50 basis points a year to investment’s contribution to GDP.
In terms of fiscal stimulus from Trump’s tax policies, it is important to remember that in addition to lower personal and corporate taxes, there are proposals that would create offsets to pay for the cuts. At the moment, Republicans are united in saying that the tax cuts and offsets are part of the same proposal and cannot be separated. Therefore, their economic impact must be assessed in concert.
There is a good reason for the insistence by many Republicans that spending not simply stay the same while tax revenue declines due to tax cuts, as this would increase our already high 102 percent general government debt to GDP levels. Here one can turn to a well-established phenomenon in economics, the Ricardian Equivalence Theorem.3 Ricardian Equivalence states that the economic outcome between debt financing and increased private spending is equal.
Or put another way, there is no free lunch. If tax cuts cause the federal debt to rise, then companies and households spend and invest less than the amount of the cut. The greater the debt level at the initiation of the tax cut the smaller the portion that is spent or invested.
While this is neutral for banks, in isolation it could hurt heavily indebted industries, many private equity structures, and companies that rely on debt versus equity financing. Proponents of the tax change argue that reducing the tax benefits of debt financing would allow better allocation of capital
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