The Trump Tax Plan: Cutting the Gordian Knot of Tax Policy Debate?

The Trump Tax Plan: Cutting the Gordian Knot of Tax Policy Debate?
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The 20th annual Milken Institute Global Conference kicked off on May 1st in Los Angeles, with an on stage conversation between U.S. Treasury Secretary Steven Mnuchin and Fox Business News anchor Maria Bartiromo.

Mnuchin was clear about the policy goals of the Trump administration. The tax proposal is only part of a broader economic reform: “We are focused on an economic plan that focuses on tax reform, proper regulation reform, and fair trade,” he told Bartiromo.

The immediate challenge is the tax proposal. He described a system with “only three lower individual rates,” but with many deductions gone [especially ones benefiting the wealthy], no AMT and no death tax. The corporate rate is lowered to 15% - this includes a “pass through” for small businesses. He said “this will spur growth,” adding "studies show more than 70% of the tax burden on business is passed on to the workers. This is our version of a ‘jobs bill.’ I hope we get bipartisan support."

Tax breaks for home ownership, retirement savings, and charitable giving will remain, however, state and local taxes may no longer be deductible, which could save $1 trillion over 10 years, inflaming governors and lawmakers in high tax states.

Regarding healthcare reform, Mnuchin observed “18 days was perhaps a bit aggressive but it looks like we’re very close to getting changes to healthcare done.” He later commented that “infrastructure likely will not be added to the tax bill. The administration will rely on public-private financing.”

Corporate Regulatory Strategy and Trade:

The Treasury Secretary supports reforming parts of Dodd-Frank that have been shown to curtail lending or were onerously complicated.

The White House proposes a one-time tax "holiday" – believed to be around 10% - to provide companies an incentive to “repatriate” assets held overseas. "We expect that trillions of dollars will come back on shore and will be reinvested here in the United States, for capital goods and job creation," Mnuchin said, adding the measure has bipartisan support. There is little doubt the tax plan is driven by a recent wave of corporate inversions.

A key part of Trump's tax plan during the campaign was to levy a tax or tariff against companies that move overseas and then try to sell their products back to American consumers. Mnuchin said they are looking at alternatives on how to structure this idea, as the border adjustment tax, in its current form, is unworkable. “President Trump is for fair trade,” he stressed, however “fair trade is not when we charge zero tariff and someone else charges 25%. The key is ‘reciprocating trade.’”

Mnuchin observed “China is a currency manipulator,” however the administration’s priority is to work with the Chinese.

A Market Based Perspective on Tax and Regulatory Reform, and Growth:

Mnuchin expressed his outlook as follows: “Although the first quarter 2017 growth rate was only 0.7%, we estimate is will take two years to reach 3% real GDP growth. As soon as we get tax reform, we’ll move on to regulatory relief.”

What do the markets tell us? As of May 1st, the Moody’s Aaa/Baa corporate quality spread is at a multi-year low, portending enormous investor risk appetite, meaning the economy is strong. Although gold turned up modestly since early 2016, it is still near a multi-year low, portending very moderate re-inflation. Combined, these conditions portend strong economic growth.

In March 2017, David Ranson, Director of Research, HCWE Worldwide Economics, using the spreads and gold, and other factors observed: “On macroeconomic grounds (capital flow motivated by pro-growth policies) I believe that real GDP will grow much better in the next year or two. This implies a big acceleration in productivity growth.” He added on 5/1/17 “…4 percent is an achievable rate of growth if the US shifts to better economic policies – less regulation, lower tax rates, a stable dollar. Success would be measured by the extent to which we could get labor force participation back up to pre-2008 levels.”

On April 21, 2017 using other techniques, Mark Skousen, editor of Forecasts & Strategies stated: “Gross output (GO), the top line of national income accounting, increased sharply and much faster than GDP in the fourth quarter 2016, indicating a robust economy for 2017. Whenever GO grows faster than GDP, it’s a good sign of economic recovery.”

Moreover, the Skousen B2B Index, a measure of business spending throughout the supply chain, skyrocketed in the fourth quarter, indicating a sharp recovery in business activity following the November presidential election. B2B transactions rose at an annual rate of 8.4% in the fourth quarter, 5.8% in real terms, the fastest rate in years.

Mnuchin’s target of 3% GDP growth in two years is within reach.

Can growth pay for the rate cuts by increasing government revenues?

Regarding financing tax rate cuts, Mnuchin commented: “we expect to pay for this through economic growth and through eliminating a lot of deductions. The difference between two and three percent GDP is close to two trillion dollars of revenues over a ten year period of time.”

Asked, “once the rate cuts are in place, can growth generate enough revenue to pay for itself?” Mnuchin responded “absolutely yeah.”

Many budget experts are skeptical of such claims, maintaining growth alone won't pay for rate cuts without some spending reduction or tax increases elsewhere.

Commentators fixated on the statutory top marginal rate, fail to acknowledge that over a long period of time, federal revenues as a percentage of GDP – the tax yield - are about 20%. What I am describing is called Hauser’s Law:

In a Wall Street Journal article in 1993, Kurt Hauser stated that: “no matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5 percent of GDP.” The federal tax yield (revenues divided by GDP) has remained close to 19.5 percent, even as the top tax bracket was brought down from 91 percent to the present 35 percent. This should cut the Gordian knot of tax policy debate!

The data show that the tax yield has been independent of marginal tax rates during this period but that tax revenue is directly proportional to GDP. So if we want to increase tax revenue, we need to increase GDP.

What makes Hauser’s law work? As Kurt Hauser said: “Raising taxes encourages taxpayers to shift, hide, and underreport income. Higher taxes reduce the incentives to work, produce, invest and save, thereby dampening overall economic activity and job creation.”

“Putting it a different way, capital migrates away from regimes in which it is treated harshly and toward regimes in which it is free to be invested profitably and safely. In this regard, the capital controlled by our richest citizens is especially tax intolerant.” 

Over the long-term, federal tax rates don’t drive federal tax revenues. Economic growth does.

“Budget Scoring”:

Economists use many complicated mathematical models; most are not reliable, as human behavior is dynamic and not static. Commenting on the dismal state of social sciences including economics, Nobel Prize winner, physicist Richard Feynman, once said “Imagine how much harder physics would be if electrons had feelings!”

Asked about budget “scoring” of the tax proposal, Mnuchin commented his staff used “dynamic scoring” models, meaning they attempt to account for significant changes in behavior.

On this subject, Ranson responded to this author on 5/3/17:

“You don’t necessarily have to raise one tax in order to offset the expected revenue loss from cutting another. It’s well accepted that “static” tax calculations produce overly pessimistic estimates. Even “dynamic scoring” is insufficient to tell the full story. The business cost of complying with a complex tax system is enormous, and nearly always ignored by the government. So there are feedback effects that are positive not just for the government’s tax receipts but also for business income. Administrative cost is another net revenue issue rarely taken into account. The chances that tax-rate cuts on capital could be self-financing from a broad national viewpoint are greatly under-appreciated.”

“Government’s objective should encourage private capital inflow from overseas and from regions of the economy where it is idle or wasted. Tax-rate cuts are a no-brainer.”

This statement also applies to excessive regulations in general, as they can be tantamount to a hidden “tax,” or what Jude Wanniski called a “wedge.”

Mark Weinberger, Global Chairman of EY, observed at Global Conference, that the administration’s current proposal is purposefully vague. It’s the “first bid” in the negotiations to a passable deal. 

If we don’t see movement on tax reform by year-end, the markets will start to doubt the Administration’s ability to deliver.

A word of caution, even if pro-growth strategies provide higher federal revenues, given Washington’s insatiable thirst to spend, there is no reason the federal deficit and debt cannot continue to deteriorate.

Jim Altenbach, CFA, is an investment advisory professional in the Los Angeles area. He can be reached at j.altenbach@outlook.com.  

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