Were you left with more questions than answers on Wednesday after Gary Cohn and Steve Mnuchin “unveiled” the broad strokes for Trump’s “massive,” “phenomenal,” “super-bigly,” tax plan?
Yes? Well that’s ok, because so was everyone.
And indeed the reaction in Treasury yields and the dollar told you pretty much all you needed to know about the extent to which this, like almost all of Trump’s promises, is short on details and long only on superlatives.
Observers, analysts, and the punditry were skeptical. Here’s a brief summary of the knee-jerk reaction via Bloomberg:
“Our first read is the ‘pay for itself with growth’ argument strikes the bond market as thin given how long it’s been waiting for any word on taxes,” FTN strategist Jim Vogel said; trading volume was significant in the reaction, he added.
Market reaction reflects the view that there’s “no way he can pass this plan,” Mischler Financial trader Glen Capelo said.
The proposal is “short on detail, more like a campaign pledge,” with “not much new info and very little on deficit implications and whether it can pass,” said Richard Gilhooly, strategist at CIBC World Markets.
For those wondering what Cohn’s
old employer thinks, you’re in luck, because Goldman is out on Thursday morning with a handy Q&A which you can find below.
Q: What did the White House announce? Treasury Secretary Steven Mnuchin and White House National Economic Council Director Gary Cohn briefed the press (April 26) on the direction that the President will take on tax reform this year. They provided little detail, and what detail was provided was mostly similar to President Trump’s campaign proposal. That said, there were some policy changes compared with the campaign proposal that provide clues about the direction the White House might take the debate. In addition, the Administration’s thinking on the fiscal impact of the tax cut is at least slightly clearer.
Q: What has changed compared with the last tax proposal?
The proposal appears to have changed in four areas compared with the campaign proposal:
- A smaller tax cut for top income earners: The White House proposal would lower the top marginal tax rate for individuals from 39.6% to 35%, rather than the 33% proposed in the campaign.
- A smaller tax cut for middle-income individuals: The proposal now calls for a standard deduction of $24k for couples rather than $30k. This is still roughly twice as much as the current standard deduction and is identical to the House Republican proposal.
- Repeal of the state and local tax deduction: The Trump campaign proposal was unclear about which, if any, individual tax deductions might be eliminated, but the current White House proposal is more specific; the deduction for state and local taxes would be eliminated, while the deductions for mortgage interest, charitable contributions, and retirement savings would be maintained.
- A territorial tax system for business income: The campaign proposal would have repealed the deferral of tax on income earned by foreign subsidiaries of US companies, and would have instead taxed those earnings at 15% minus foreign tax credits, amounting to what would effectively be a 15% minimum tax on foreign earnings. Instead, the revised White House plan would adopt a territorial tax system, which exempts foreign earnings from US tax.
In addition to the explicit changes compared to the campaign proposal, today’s announcement was also noteworthy for two conspicuous omissions.
- No border adjustment: The plan does not endorse the border adjusted tax (BAT) that makes up part of the destination-based cash flow tax (DBCFT) system in the House Republican blueprint. In comments earlier in the day, Treasury Secretary Mnuchin indicated that the White House did not support the BAT in its current form, though he suggested that revisions might be considered. In light of substantial opposition to the BAT in the Senate, it would have been very surprising to see the White House endorse the proposal. That said, today’s announcement did not include an outright rejection of the proposal either.
- No mention of interest deductibility or capex expensing: The Trump campaign proposal would have allowed businesses the option of full expensing of capital investment in return for non-deductibility of interest expense. However, today’s outline is silent on this question. This is notable since many observers assume that the White House does not support the mandatory shift to full expensing of capex and non-deductibility of interest included in the House Republican blueprint
Q: What effect would these revisions have on the size of the proposed tax cut?
Overall, we figure that the changes the White House has announced would shrink the size of the proposed tax cut by more than $1 trillion over ten years compared with the prior version:
- A standard deduction of $24k for couples costs about $300bn less over ten years than the $30k standard deduction proposed in the campaign;
- A 35% instead of 33% top marginal rate for individuals probably reduces the cost of the proposal by around $400bn over 10 years;
- Repeal of the state and local tax deduction would raise around $800bn in tax revenue; and
- The shift to a territorial tax system would reduce corporate tax receipts by $200bn to $300bn more over ten years than the prior proposal.
- With these changes, we expect that the overall cost of the tax plan would decline from the roughly $6 trillion cost over ten years previously estimated by the Tax Policy Center (TPC) to just under $5 trillion.
As noted above, it is unclear how the proposal would treat capital investment and interest expense, but if the proposal omitted any changes in this area, it would shrink the cost of the proposal over the next ten years by another $1.3 trillion to around $3.7 trillion, based on TPC estimates.
Q: Where does this put the proposal in comparison with the House and Senate?
It brings the White House proposal closer to where Congress is likely to be on most issues, but the rate cuts on corporate and business income are still greater than we think Congress will support. On the individual side, we believe that a 35% top marginal rate is more likely than the 33% rate that House Republicans have proposed, given fiscal constraints and the fact that a 35% rate would be a natural place to settle, as it was also the top rate prior to 2013.
The White House’s proposed $24k standard deduction and elimination of the state and local deduction bring it into line with the House Republican blueprint. While we are skeptical that the state and local tax deduction will be repealed entirely, we note that the House, Senate, and White House now all appear to be focused on limiting this benefit, suggesting that at least a limitation is becoming more likely.
On the corporate side, the inclusion of the territorial system for corporate income in the White House plan brings it in line with the House proposal as well as the position that we expect the Senate to take. However, the 15% rate that the White House proposes on corporate and pass-through business income is lower than the 20% and 25% rates, respectively, that the House proposes or that the Senate is likely to agree to. Ultimately, we expect that Congress will cut the corporate rate to perhaps 25%, and we would expect the tax rate on small business to be higher—quite possibly still aligned with the top individual tax rate.
Q: What have we learned about how the tax cut might be paid for?
Secretary Mnuchin has stated that the tax proposal would be offset through a combination of growth and various base broadening measures. We expect this to be outlined in more detail by May, when the President submits a formal budget to Congress for fiscal year 2018, including projections of revenues and deficits over the next ten years. Our preliminary expectation is that the White House will assume that the majority of the fiscal effect of the tax cut would be offset through a projection of faster GDP growth. For example, if the White House assumes a 3% growth rate over the next ten years, rather than the 1.8% average rate that CBO assumes, this would increase revenues by roughly $3.7 trillion over the ten- year period. We note that the fiscal benefits of a higher trend growth forecast are very backloaded; over half of the total revenue gain over the ten-year period would come in the final three years, so the projected deficit over the next several years would expand as a result of the tax cut, regardless of what growth assumptions one makes
White House growth projections would have little direct effect on the legislative process in Congress, whereas the Joint Committee on Taxation (JCT) will use growth projections provided by the CBO as a starting point for analysis and is likely to make much more conservative estimates of the effect that tax legislation is likely to have on growth. That said, optimistic White House growth assumptions might help build political support in Congress for the eventual legislation. With apparent support for an explicit tax cut from key Republicans like Senate Finance Committee Chairman Orrin Hatch (R-UT), momentum for a tax cut rather than revenue-neutral reform appears to be growing.
Q: Won’t Senate rules make it difficult to pass a tax cut that is not paid for?
Rules regarding the “reconciliation” process make it more difficult to pass a tax cut than to pass revenue-neutral tax reform, but we expect lawmakers to get around these obstacles. Republican leaders have made clear their intent to use the reconciliation process to pass tax legislation, since this allows the Republican majority to circumvent likely Democratic opposition in the Senate. However, the “Byrd Rule” in the Senate prohibits reconciliation legislation from increasing the deficit after the period covered by the budget resolution that governs the process, which traditionally lasts for ten years.
The most obvious way that congressional Republicans might get around this constraint is simply to allow the tax cuts to expire after ten years (i.e., by 2027). This was done in 2001 when the Bush Administration passed a large individual tax cut. However, two reasonable objections to this have been raised. First, structural reforms to the tax code could do more harm than good if they were made temporary. That said, a simple tax cut (for example, dropping the corporate rate from 35% to 25%) would not be as difficult to implement on a temporary basis, particularly since we expect that there would be a widespread belief that such a tax cut would be extended or made permanent before it expires, just as the 2001 tax cuts were for the most part.
A second, more technical, objection has also received some attention recently. The JCT has indicated that the revenue loss associated with a temporary tax cut would continue several years after it expired, because companies might postpone their use of certain tax benefits until after rates have risen and might pull forward income that would otherwise be recognized later. The JCT estimates imply that allowing a 20% corporate tax cut to expire after nine years would result roughly a $90bn revenue loss in the second decade, which would violate the Byrd Rule. However, this would become a much less important consideration if a corporate tax cut were considered as part of a larger package that also included some permanent provisions that raised revenue, considering that the House and White House proposals would already raise hundreds of billions of revenue through base broadening in the second decade, even excluding the effects of controversial proposals like border adjustment.
Q: Now that the White House has made its proposal, what happens next?
There are four important milestones coming up over the next few months:
- The President’s Budget: The White House is expected to submit its budget proposal to Congress in mid-May. We would expect this to include some additional detail regarding tax legislation—at a minimum, it is likely to include more specifics regarding the potential effect on revenues and the deficit—as well as an a general indication of the scale of its infrastructure plan.
- The final disposition of the health bill: House Republicans look likely to make another attempt at passing the American Health Care Act (AHCA), after announcing modifications intended to satisfy the conservative and centrist Republicans who signaled they would oppose the prior version. However, the announced revisions appear likely to increase support among conservative Republican lawmakers but they do not appear to have shifted the views of centrist Republicans nearly as much. As of this writing, consideration of the revised health bill within the next week or so appears possible but not likely unless it becomes clear there will be adequate support. Even if health legislation passes in the House, we do not expect a majority of the Senate to support the House version, and developing a bill that can pass the Senate is likely to take several weeks, at least. The upshot is that Republican leaders will soon need to decide whether they can pass a health bill in the House, or officially postpone consideration and move on to other issues, since the budget and tax process cannot move forward until they do.
- The congressional budget resolution for FY2018: At the start of the year, Congress passed a budget resolution for FY2017, which served the sole purpose of providing instructions to the committees with jurisdiction over the Affordable Care Act (ACA) to pass health legislation using the reconciliation process. It was expected that a second resolution for FY2018 would then be passed once health legislation had been enacted, in order to provide instructions for passage of tax reform legislation. With health legislation in legislative limbo, it is unclear whether Republican leaders will pass a second budget resolution this year. However, since the instructions under the FY2017 resolution called for legislation that was roughly budget-neutral, the only way Congress can pass a meaningful tax cut would be to win bipartisan support, which seems unlikely at the moment, or to pass a new budget resolution that explicitly instructs the tax-writing committees to cut taxes.
- Draft tax legislation released: It is difficult to predict when tax legislation might be made public in the House or the Senate, but our expectation is no earlier than June and possibly not until July. In the near term, we expect the tax-writing committees, particularly the House Ways and Means Committee, to hold hearings examining some of the key issues in its proposal, like the border-adjusted tax. Once the procedural groundwork for a committee vote has been laid, by passing a new budget resolution or re-using the instructions intended for the health bill, the committee is likely to release its proposal to the public and pass it quickly. In the Senate, the timing is even more fluid; we expect more detail from the Senate Finance Committee over the next couple of months regarding its likely approach for tax reform legislation, but a formal proposal appears to be a ways off.
The extended timeline for even releasing a draft proposal suggests that while the House could vote on tax legislation in committee before August, a vote on the House floor is less certain, and Senate passage before August looks very unlikely. This suggests that tax legislation is unlikely to become law before Q4 2017. While enactment shortly before year-end is a clear possibility, we believe it is more likely to become law in Q1 2018.
We continue to believe that tax legislation is fairly likely to become law. In fact, market sentiment regarding fiscal policy might have become too negative. This is a substantial shift from the start of the year, when sentiment among market participants took a much more positive view regarding the potential for major policy changes. However, we expect the process to continue slowly over the next couple of months, and without any clear signs of progress financial markets are apt to take a wait and see attitude toward tax reform.