November 15, 2017

Stocks gave ground yesterday following the lead from overseas. Continued negative reaction to General Electric’s# big investor meeting also cast a bit of a pall over the market. A rally in the euro suggested that Europe is on a better economic path than the United States.

The big focus this week and next will be on Washington and the progress of the tax bills through both chambers of Congress. The Senate last night released its first markup of the Senate Finance Committee’s version of the bill. The highlights of the changes are:

1. Repeal of the original Obamacare mandate that everyone be covered by essentially reducing the penalty for non-compliance to zero. That will result in an estimated 13 million Americans (mostly young and healthy) dropping insurance coverage. It also almost certainly means higher rates for those who buy their health insurance on the Federal exchanges rather than through work.
2. The child care credit is expanded from the original $1,000 to $2,000.
3. Individual tax rate changes will expire in 10 years, while the reduction in the corporate rate will be made permanent. That is required because under Senate rules, the reconciliation process that allows the bill to pass with a simple majority allow a cumulative $1.5 trillion addition to the deficit over 10 years, but none after that.
4. The balance of the changes I would describe as tweaks that don’t fundamentally change the bill but are included to satisfy either individual Senators or special constituencies.

Under the Senate version, about 9% of Americans will pay more in taxes. For the most part, these are people in high tax states who would lose the ability to deduct state and local taxes. Who wins? The further up you go on the income ladder, the more likely you are to pay less in taxes than you do today. The doubling of the standard deduction provides meaningful help to many lower income workers. The elimination of the alternative minimum tax and the ability of small business owners to pass through income to their personal return at lower rates are a big help to higher income workers. The Senate plan makes seven tiered income brackets stopping at 35%, while the House version has four brackets that go all the way to 39.6%. In fact, due to a quirk, some will actually pay closer to 45%. Assuming both bills pass, they will have to be reconciled in joint committee before being sent on to the President.

The next several days are when the rubber meets the road. So far, only a few members of the House from high tax states that will lose the ability to deduct state and local taxes have come out in opposition to the bill. In the Senate, where at least 50 of 52 Republicans have to support the bill, none have come out against it yet. The decision to revoke the individual mandate might risk losing Susan Collins’ vote, but it also might insure getting the vote of Rand Paul. To be sure, there are a few key votes in the Senate at both ends of the spectrum. Until we get closer to the vote, it is hard to determine who’s on board and who isn’t.

While it was three votes in the Senate that doomed healthcare, the Republicans could have a tougher time in the House where there are close to 50 party members from high tax states. Not all constituents itemize deductions. Lower income workers would benefit from an increase in the standard deduction despite the repeal of the ability to deduct state and local taxes.

There are arguments for and against the deduction. The standard argument for eliminating it is that those in low tax states effectively subsidize those in high tax states who take big deductions on their tax bills by deducting state and local taxes. On the other hand, voters in states like New York can point out that local taxes have been deductible for over a century. Moreover, New Yorkers now pay more in taxes to the Federal government, even after the deduction than they receive back in Federal goods and services. One should also note that the higher-taxed northern states have more aging infrastructure and weather conditions that are harsher to roads and bridges. Whatever the arguments, Congress votes based on a lot of factors. Fairness is rarely one of them.

The current set of bills is largely designed to lower corporate taxes, and make the U.S. more competitive worldwide. If passed, it will likely keep American companies from being domiciled abroad, and it may entice some foreign companies to build plants here. It would also simplify tax preparation for those who can take advantage of the doubling of the standard deduction. Finally, for those at the top end of the income scale, there will be some benefit for the next decade.

Economically, the bills would expand the deficit for years to come unless their impact helps to raise America’s growth rate immediately. Despite Presidential tweets, that is unlikely unless Corporate America suddenly feels emboldened and embarks on a massive collective program of capital investment. What is more likely is that Corporate America will share part of its savings with its shareholders and part with its customers through lower prices. As I have noted previously, capital expansion is tied to growing demand, not more cash on hand. It is certainly possible that if personal disposable income rises, we will collectively spend more. But once again, the bulk of the tax savings go to corporations and high income individuals who are not likely to alter spending habits a great deal. Certainly, this bill won’t reduce growth rates. But I would be surprised if, ultimately, the U.S. growth rate rises more than a couple tenths of a percentage point.

Perhaps the biggest corporate beneficiaries of the tax bill will be technology firms. One definition of GDP growth is to multiply the growth rate of the labor force by the increase in the rate of productivity. Nothing in this bill is likely to change the growth rate of the labor force. That is a function of demographics and immigration. If anything, Trump immigration policies will lower this growth rate ever so slightly. Therefore, any acceleration will have to be tied to productivity gains, and that is where technology comes into play. The movement to the cloud could be accelerated if companies have more cash to invest. Repatriation of foreign earnings might also help, although history shows that most repatriated cash goes to shareholders in some fashion.

Investors would also stand to benefit because lower corporate taxes imply higher corporate profits. Even if some of the benefit is “shared” with customers, the owners of the business, the shareholders, stand to benefit.

Thus, stocks over the next ten days could move in either direction, depending on the outcome of votes to come in the Senate and the House. While this may only be the first shot at tax revision, it is the best shot. If bills are defeated in either chamber, future iterations will have to be more than a small tweak. Every restored deduction will have to be offset by a new tax or equivalent penalty. What we do know is that there will be no Democratic support. None was sought in the process of creating the bills, and none is likely to be forthcoming. As for the Republicans, those on the fence have to be listening to constituents. Those in the House are less than a year from seeking reelection. While all have been getting an earful, both good and bad, nothing really counts until the final version subject to a vote is actually on the table. As with healthcare, Republicans are not allowing much time between the release of the bill and the vote. It worked against them in healthcare; we’ll see what happens this time.

When Trump was elected President, markets rallied fiercely for several months before reality set in. After that, bond yields came back down and the dollar rallied. The same could be set to happen again. Investors will almost certainly be enthusiastic buyers of stocks and sellers of bonds. But if the hype fails to turn into reality, if growth doesn’t move up rapidly in 2018, reality might prove more sobering. However, let’s not get ahead of ourselves. Nothing has passed yet. The next two weeks will be important ones.

Today, NCIS star Sean Murray is 40. Ed Asner turns 88.

James M. Meyer, CFA 610-260-2220

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