At some point, everyone is probably going to get tired of talking about what Friday’s D.C. debacle means for tax reform, but as of Tuesday morning, that’s still front and center on investors’ minds.
And don’t get me wrong, it’s not like this isn’t going to continue to be one of the most important issues going forward, but markets have short memories and investors are a myopic bunch so pretty soon they’ll be something else to talk ceaselessly about like say Devin Nunes getting banished to Siberia or the French elections.
For now though, everyone is still laser focused on whether and to what extent the growth-friendly parts of the Trump agenda can be salvaged. We heard from Barclays on Monday evening. The bank provided the following handy visual that depicts all the other things Trump will invariably fail to negotiate:
Well on Tuesday we get Goldman, which is nice considering how many of the bank’s former employees work for Trump. I mean Jesus, you’d think if there were anyone who has a read on things it’s Gary Cohn, right? Of course don’t forget, Gary is another one in Bannon’s crosshairs:
Anyway, below find the Squid’s take on where we stand and where we (might) be going.
The failure to pass the health legislation was a clear political setback for the new administration and congressional Republican leaders. It leaves a major campaign priority unaddressed, with little chance of near-term resolution.
Does the failure of the health care bill also imperil tax reform? From a procedural perspective, the answer is clearly no. The legislative process on tax legislation could not begin until work on the health bill had concluded (either by passing the health bill or giving up) because the health bill was moving through the legislative process under procedural protections (so-called “reconciliation instructions”) granted by the FY2017 budget resolution. Tax reform was expected to move under the same type of procedural protections under the FY2018 budget resolution that had been expected to pass in the next several weeks. Passing the FY2018 resolution would have made the FY2017 resolution obsolete and would have removed the procedural protections for any bills related to it, like the health bill. As a result of this unusual legislative strategy—using two budget resolutions in the same calendar year— congressional Republicans were forced to delay work on tax reform until work on the health bill was completed (or abandoned). From a timing perspective, the failure of the health bill thus actually accelerates tax legislation slightly.
From a fiscal perspective, passage of the American Health Care Act (AHCA) would theoretically have made tax reform easier in two ways. First, it would have repealed nearly all of the taxes enacted in the Affordable Care Act (ACA), reducing revenues by $1 trillion over ten years. This would have lowered the projected baseline revenue level that a new tax system enacted in tax reform legislation would have needed to achieve. Second, the bill was estimated to reduce the deficit by around $150bn on a net basis, even after accounting for the repeal of the ACA taxes, because it cut spending by even more than it cut taxes. That savings could have theoretically been used to offset the cost of tax cuts later this year.
Over the next few weeks, we will be watching to see how the White House and congressional Republicans approach three of the most important fiscal questions related to tax reform:
- Border adjustment: The difficulty that congressional Republicans had in passing complex health legislation with uncertain consequences suggests that they are likely to have trouble passing complex tax legislation with uncertain consequences. The border adjusted tax (BAT) that makes up part of the destination-based cash flow tax (DBCFT) proposal is an example of such a provision, which also appears to lack support among members of the Freedom Caucus. The White House has not taken a formal position yet but, given the lack of support for the BAT in the Senate and potentially even in the House, the White House might want to steer congressional Republicans away from the BAT to avoid another failed vote on a key priority.
- Revenue neutrality: Without the BAT, it will be difficult to enact revenue-neutral tax legislation that meaningfully reduces the corporate tax rate while also providing a reduction in personal taxes, assuming that ambitious base broadening will be as difficult to pass along party lines as the health bill was. Our expectation is that congressional Republicans will soften their insistence that tax legislation (corporate and personal) be revenue neutral. This could lead to a combination of temporary tax cuts combined with permanent reforms. One notable development came on March 26, when Freedom Caucus Chairman, Rep. Mark Meadows (R-NC) stated with regard to tax legislation that “…there has been a lot of flexibility in terms of some of my contacts and conservatives in terms of not making it totally offset… But does it have to be fully offset? My personal response is no.”
- The budget resolution. While conservative Republicans seem likely to support a net tax cut, there are two potential limiting factors. First, there is some discussion of reusing the “reconciliation instructions” from the FY17 budget resolution. This would seem to impose a strict revenue neutrality requirement on the tax bill, since the current resolution requires $2bn in net savings over 10 years, not a tax cut. If instead Republicans try to pass an FY18 budget resolution, we expect the limiting factor to be centrist Republicans, particularly in the Senate, as Republicans try to resolve three priorities: (1) making room in the budget resolution for a net tax cut (a potential necessity to enact significant tax legislation); (2) eliminating the projected budget deficit by 2027 or sooner (a conservative priority); and (3) minimizing cuts to domestic spending, including entitlement and safety-net programs (a centrist priority).
Ultimately, we expect tax legislation to look more like a tax cut, with a few elements of reform, rather than a comprehensive overhaul of the corporate and individual tax systems. This would be more likely to find sufficient support in Congress than the failed health bill, for example, because it would generally provide new benefits, in the form of tax cuts, rather than take existing benefits away.
The decisions Congress makes over the next several weeks will determine whether a tax cut will be achievable.