November 13, 2017

Stocks were mixed on Friday.  For the week, stocks fell for the first time since early September.

A lot of the focus for investors has been on the progress of tax reform.  Wall Street has generally been favorably inclined towards both the House and Senate versions to date.  While some, notably in high tax states, have whined a bit, for the most part, high income investors will pay less under both versions and corporations will pay a lot less.  That means higher profits, and hopefully, higher stock prices.  What’s not to like?

But let’s look at the plans at a more basic level.  The budget plan passed before either tax plan was released allows for up to $1.5 trillion in additional deficits over the next year.  Deficit spending means simply, that the government will spend beyond its means.  Actually, since it has been running high deficits for years, it means that Congress would allow itself to spend even further beyond its means.  Intuitively, that doesn’t sound like the smartest idea on the planet, and indeed, it isn’t.  When one borrows, an interest rate is paid.  That rate is based on a lot of factors including inflation.  It also is based on the lender’s faith that the borrower can pay back the money.  Now the U.S., of course, can print money so in the abstract, there is no real fear that debt won’t be repaid.  But debt is always repaid in tomorrow’s dollars.  If inflation saps the value of the dollar, and if immense borrowing casts further doubt, then the lender will demand a higher rate.  If the rates go up and the borrower keeps coming back, one can see a death spiral coming.  We last saw that happen with Greece.

Now, the U.S. is far from Greece, but as I noted last week, if one adds $4-5 trillion to the nation’s debt over the next five years (and that includes planned sales of debt holdings to the public by the Federal Reserve), and interest rates climb, our nation’s debt service costs will escalate.  At some point they will reach a limit that would push interest rates to uncomfortable levels.  Again that is what happened to not only Greece, but to much of southern Europe in 2010-2011.  Said in more basic terms, if we borrow too much today, we are going to have to pay the price tomorrow.

But President Trump and supply side economists say, “Not so fast!”  They claim growth, stimulated by lower taxes, will increase Federal revenues even with lower tax rates, and everyone will win in the end.  Sounds great.  Except there is very little history tying changes in economic growth rates to changes in tax rates.  Supply siders point to the Reagan years as a prime example to back their point.  But today and the early 1980s are totally different.  Back then, interest rates were just coming down from sky high levels.  The world economies were emerging from a recession.  Most important, our national debt was less than 20% of what it is today.  Thus, in the early 1980s, growth was beginning to accelerate, there was plenty of slack in the economy and interest rates were falling rapidly, even as annual budget deficits grew.  Today, interest rates are near historic lows and while one can argue about how much slack exists in the economy it is nowhere near where it was when the Reagan tax cuts were passed.  In fact, I can’t remember a time when large tax cuts were legislated and the economy was many years into a recovery.

Next, let’s look at the way taxes are changed under the bill.  Under both proposals, the primary beneficiaries of the tax cuts are corporations.  In fact, in the House version, all of the net reduction is consumed by businesses.  Supply siders will argue that if businesses have more money, they will invest more.  But investment isn’t tied to money on hand; investment is tied to perceived demand growth or a desire to increase productivity.  Since the Great Recession ended, corporations have been immense borrowers of money even as free cash flow rose.  Why?  To buy back stock and increase dividends.  That may be good for shareholders, but it does nothing for economic growth.  There is nothing in either the House or Senate bill that forces corporations to invest part or all of their savings related to lower taxes.  There is nothing to tie the repatriation of foreign earnings to increased investment.

Of course, there is merit to cutting corporate taxes, especially as the rate paid by companies doing business in America is just about the highest in the world.  We live in a global world and businesses can invest anywhere.  Logically, the first reason to invest in a particular geography is to be near one’s customers.  But probably of equal importance is cost, and taxes are certainly one big cost.

A corporate tax cut that would not inflate our deficit or debt would make perfect sense.  We have heard for years the notion of flattening and broadening the tax base.  That means lowering the top rate and getting rid of as many deductions as possible.  That holds true for both corporate and individual taxes. The problem is that for every planned elimination of a deduction, there is a large group of taxpayers who will scream and yell.  Historically, politicians don’t have a very good record of standing strong while constituents scream.  Almost by definition, those losing tax breaks will scream loudly; those getting tax breaks will tend to keep quiet.

For better or worse, Republicans have chosen to go it alone on this tax bill.  While there are features some Democrats will like, such as doubling the standard deduction for individuals or lowering the corporate tax rate, few, if any, are likely to buy into the whole package, especially since they have been shunned from offering any input to date.  So Republicans will allow themselves very little wiggle room, just 2 or 3 votes in the Senate depending on the outcome of the December election in Alabama, and less than two dozen votes in the House.

If Republicans can’t get either a combination of the current House and Senate bills passed, no doubt they will keep coming back with variants just as they did with healthcare.  It is possible that what passes, if anything, will be a much slimmed-down package of what’s on the table today.  If the current set of bills fail, there is little doubt that Wall Street will react negatively. Hopes are up, even if we debate how much tax reform is already built into stock prices.  I would argue not all that much, given the Republican record of success in 2017 to date.  But I won’t be among those crying.

I sort of like 2-3% growth with little government interference.  You know the old saw, ”It’s not nice to fool with Mother Nature.”  If growth is stimulated too much, the Fed will be forced to increase interest rates at a faster pace.  If growth isn’t stimulated, then the deficit will grow quicker than it has, and the day of reckoning when debt service requirements force serious cuts in entitlements will come sooner.  Even if you are a believer in large scale entitlement reform, what that will entail is a shift in the burden of supporting the poor and the elderly from the Federal government to the private sector.  That won’t be positive for economic growth.

The best package would probably be a more moderate cut in corporate taxes (maybe to 25%), budget neutrality, repatriation of overseas earnings tied to some commitment to invest, and some effort to clean up some deduction abuses.  I doubt all of that is possible but some is.  If the current package loses and a more modest package that doesn’t balloon the deficit takes its place, we will all win in the end.

Today Jimmy Kimmel is 50.  Whoopi Goldberg is 62.

James M. Meyer, CFA 610-260-2220

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