US tax plan: Significant cut in personal and corporate tax rates - Westpac

Richard Franulovich, Research Analyst at Westpac, notes that the Trump administration and congressional Republicans have released their tax framework and as widely reported the centerpiece is a significant cut in personal and corporate tax rates.

Key Quotes

“Significant procedural, fiscal and political constraints are likely to become more apparent in coming weeks.”

“The Trump administration and congressional Republicans have released their tax framework. As widely reported the centerpiece is a significant cut in personal and corporate tax rates:

• a cut in the corporate income tax rate from 35% to 20%
• a switch from seven personal income tax brackets to three (12%, 25% and 35%), possibly a fourth bracket for high incomes, though it does not define the income levels to which they all apply
• a new 25% tax rate for so called “pass thorough businesses” (i.e. small business) which pay taxes based on the individual brackets
• a doubling of the standard deduction (a fixed amount of income that is exempt from taxation for all taxpayers)
• a deemed repatriation for profits accumulated overseas
• elimination of the state and local tax deduction (though maintaining the mortgage interest deduction) and allowing business to write off capex faster”

“Both the USD and US fixed income yields will be pressured higher near term amid heightened hopes for tax cuts. But, as negotiations intensify in coming weeks significant procedural, fiscal and political constraints are likely to become more apparent. The final version is likely to be delivered later and will in all probability be smaller in scope:

• Fiscal math does not add. Independent analysis has costed a corporate tax cut from 35% to 20% at $1.8trn over a decade, a lower rate on pass through income (i.e. small business tax cut) at $500bn over a decade and personal income tax cuts at $1.4 to $1.9trn, depending on what income levels the proposed 12%, 25% and 35% brackets apply. Allowing businesses to write off capex over a faster period loses another $500bn over a decade. That nets to revenues losses of $4.2-$4.7trn over a decade. It is extremely unlikely that the repeal of various deductions will come anywhere close to bridging the gap and as such centrist mainstream Republicans are unlikely to buy into this package. The Republican led Senate Budget Committee has already agreed to a materially smaller $1.5trn tax plan, highlighting the enormous divide among the Republicans, despite the appearance of unity.
• Unrealistic revenue offsets. Repeal of the state and local income tax (SALT) deduction could raise $1.3trn in a decade but will face intense and probably insurmountable opposition. The biggest beneficiaries of this deduction reside in states where local taxes are high - notionally Democratic states like California, New Jersey, New York and Connecticut. However, there are 33 House Republicans from the ten states that disproportionately benefit the most from this deduction. Their opposition will be easily mobilised. Some Republicans have already come out against the repeal of this popular deduction. Absent meaningful revenue measures the final size of any tax cuts will need to be scaled back. Other measures such as a one-time tax repatriation holiday and eliminating the deductibility of interest expenses for businesses do not raise enough revenue, while border adjusted taxation and the repeal of the affordable health care act - which could have created more than $2trn in fiscal space - lack support.
• Procedural obstacles in Congress. On substantive grounds broad based bipartisan tax reform is the favoured approach but the price for Democratic support is too steep - they will oppose large scale corporate and high income tax cuts. The GOP will pursue tax cuts on a partisan basis but lack votes in the Senate to overcome a “filibuster” (60 votes), a tactic Democrats are sure to use to stall tax legislation. “Reconciliation” offers a workaround. This budgetary approach requires a simple 51 vote majority but to unlock this “fast track” Senate rules require: 1) a fiscal budget be passed first; and 2) no measures can add to the deficit beyond a 10 year window. The Republican party has yet to pass a budget due to infighting over welfare cuts (favoured by the House Freedom Caucus but opposed by many mainstream centrist Republicans) while the 10yr rule implies tax cuts must be ultimately revenue neutral. In the absence of any revenue offsets that raises the prospect of a temporary 10 year tax cut.
• Dynamic scoring only goes so far. A 3% growth over a decade vs 1.9% that the CBO currently assumes will raise $3.5trn in additional revenues but officials neglect to mention that faster growth implies higher interest rates, raising debt servicing costs and higher inflation, raising mandatory welfare spending. If interest rates are 1ppt higher over a decade and inflation tracks closer to 2.6% - not unreasonable if one assumes decade average growth of 3% - around 2/3s of the revenue benefits that flow from faster growth are eaten away. Faster growth is no elixir and in any case the official scorekeeper, the CBO, is unlikely to be cajoled into an unrealistic assumption that growth will average 3% over a decade, regardless of what the Administration will assume.
• A tax repatriation holiday is the lowest hanging fruit - the idea is not controversial and enjoys bipartisan support. Timing suggests that if tax cuts are passed it will be implemented in calendar year 2019. About 30% of the stock of US earnings offshore were repatriated in 2005. Applying a similar ratio to today’s $2.6trn+ overseas hoard implies a hefty $780bn+ in repatriation. But, a substantial majority of that is USD denominated. Company filings from the largest holders of offshore earnings suggest 80%+ is in USD securities. Even so, that still implies a hefty $150bn+ in corporate demand for the USD. While negligible compared to daily FX turnover it still represents a positive tailwind for the USD that cannot be ignored.
• Tax cuts are likely to have a modest impact on growth. The fiscal multiplier on corporate tax cuts and high income earners is typically well below 1.0 given their propensity to save. Hurdle returns for new business investment are already low thanks to the historically low cost of debt and equity capital yet investment has been sub-par for some time. As the slide below shows the share of internal funds and debt issuance devoted to capex is in deep structural decline. Against that the share of business funds devoted to dividends and share buybacks has been on a trend increase for the better part of 30 years.” 

“Where to from here? Both the USD and US fixed income yields will be pressured higher near term amid heightened hopes for tax cuts. But, as negotiations intensify in coming weeks significant procedural, fiscal and political constraints are likely to become more apparent. Congress sits for barely 30 days in the current calendar year. Tax cuts are unlikely to be passed inside this small window. And, given the aforementioned obstacles the final package is likely to be smaller than today’s plan.”