December 1, 2017

Stocks moved sharply higher both yesterday and the day before as tax legislation appeared to be marching toward a successful conclusion in the Senate. While the Dow soared, not all stocks followed. Tech shares took a beating on Wednesday as money rotated toward 2017’s losers and companies with high domestic tax rates that do most of their business in the U.S. Yesterday, tech stocks started to regain their footing but lagged meaningfully while the “winners” of tax reform kept moving higher. However, overnight, the path toward conclusion hit a pothole as it was determined that a triggering mechanism designed to force a tax increase or spending cuts in the event deficits rose too much would violate Senate rules.

So, it is back to the drawing board this morning. Futures are off. The Senate reconvenes at 10:00 and is expected to debate the first set of new amendments at 11:00. If you understand the expression, “where there is a will, there is a way,” you understand the path Republicans in the Senate are likely to follow. The talk overnight was a stairstep concept where corporate tax rates would be cut to 20% initially and then rise slowly to levels still well below today’s 35%. That concept is almost certain not to make it into final law. As with the healthcare debate, Republican leadership wants to get something, actually almost anything, passed in order to move to the next step, reconciliation between the House and Senate bills. The reconciliation process gives Republicans one last chance to pull the right levers that leadership hopes will get passed in both chambers of Congress. By rule, whatever comes out of reconciliation is subject to a straight up or down vote. If it passes, it becomes the new law. If it fails, then it is back to square one, both chambers would have to start again.

Clearly, there is a basic framework. Corporate taxes would be reduced to 20% or close to that level. So far, the White House is sticking to the 20% number, but nothing is off the table. If that number has to be 22% to get the numbers to work and the necessary votes to ensure passage, then that is what it will be. Both sides agree that individual tax cuts have to reach most Americans recognizing that there are a few combinations, mostly affecting those in high tax states, that might not get a tax cut out of this package. Other agreed upon conditions (at least for the moment) are a doubling of the standard deduction, elimination of the personal exemption, and elimination of the alternative minimum taxes. Items to be tweaked in order to make the numbers balance include child care credits, property tax deductions, starting and ending dates for some changes, the pass-through rates for small businesses, and the overall size of the allowable deficit. Most neutral entities that have scored the Senate bill agree that growth alone is unlikely to offset the static deficits.

It is still likely that the Senate passes something before the end of the weekend. Whatever it passes will be a work in progress and should not be taken literally as the final bill. Taking the next step to reconciliation clearly carries its risks for Republicans. Leadership isn’t going to know for sure that the package that comes out of reconciliation is going to pass both chambers, and there is no mechanism to make changes once the reconciliation process is complete. The issues that must be solved to gain 50 votes in the Senate are not necessarily the same as the issues confronting the House. For instance, there are very few Republican Senators in high tax states, but there are almost 50 Republican members of the House who have to be concerned about the impact of removing the ability to deduct state and local taxes. The Senate version of the bill removes penalties related to the individual mandate under Obamacare. The House version has no mention of the individual mandate.

Of course, the biggest source of revenue loss in the two bills comes from the lowering of the top corporate tax rate from 35% to 20%. Every time tax writers have to soften the impact of deductions taken away (e.g. allowing property tax deductions up to $10,000), they must find a revenue offset. That gets harder and harder if one insists that the corporate rate has to be 20%. Trump doesn’t budge easily, but more than anything, he wants to be able to declare victory. If it gets to the point where allowing the decrease in corporate taxes to be only to 22% is the only way to secure passage, he will probably capitulate.

A lot has been said about how the U.S. corporate tax rate of 35% is about the highest in the world. Reducing it to 20% won’t make it the lowest, but it will be well below the median. However, left out of that simplistic discussion is that fact that almost all of the rest of the world uses some form of value-added tax similar to the border adjustment mechanism Republicans tried to insert originally into the House bill. The U.S., at the moment, has no such tax. Thus, there really is room to give and still keep U.S. businesses highly competitive. There is nothing special about 20% except for the fact that President Trump made that number such a big issue, and he doesn’t like to give ground easily.

Today, the markets are likely to be very volatile as various trial balloons are floated in the Senate. Every time one explodes, markets will fall. Every time an idea catches on and seems to be the key to final Senate passage, the market will go up. The reality, though, is that markets will close before final resolution. The Senate will stay in session tomorrow to complete (hopefully) the process and send something on to reconciliation. That process will probably take weeks, as leadership will have to continue going back to wavering constituents to get feedback. They don’t want any bill to come out of reconciliation that they aren’t confident will achieve final passage.

In politics, nothing is guaranteed. In 2017, Republicans haven’t had many successes. They want this one badly. Will it be good legislation? The best answer is that it will probably be flawed. Too many last minute patches that aren’t well thought out will ultimately need fixing. That, in fact, was how Obamacare got passed and clearly, despite what anyone thinks of its overall benefits or lack thereof, it has had its fair share of rough spots and certainly wasn’t successful in lowering health insurance costs.

Today, DeSean Jackson is 31. Sarah Silverman is 47. Bette Midler is 72 while Woody Allen turns 82.

James M. Meyer, CFA 610-260-2220

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