November 8, 2017

Stocks were mixed yesterday in a relatively quiet session. Oil prices stabilized after sharp gains Monday in the wake of turmoil in Saudi Arabia. President Trump’s Asian trip continues without much controversy to date although the major meetings still lie ahead. The dollar has continued to edge higher, while interest rates slowly decline.

At home, the focus in Washington remains on tax reform. The Congressional Joint Committee on taxes has weighed in. In general, most Americans, according to the Committee, will receive some tax breaks over the next 10 years, but the impact is uneven across both income classes and geographies. The biggest winners are those making substantially over $1 million and those families earning roughly $200,000 per year. Those that benefit the least are generally those making less than $50,000 and surprisingly, those making exactly $1 million. The tax benefits tend to moderate or even disappear around 2023-2025 before improving again. All this is the result of many moving parts. These impacts I just described are for individuals. Corporations and most pass-through S Corps reap significant benefits over the next 10 years except, of course, those few corporations whose ability to take advantage of big loopholes now pay less than 20% on their U.S. derived income.

As you might expect, both Republicans and Democrats have their talking points. Democrats rightfully note the huge benefits to the super rich, the impact on those in high tax states, and the modest benefit (but still a benefit) to those making less than $30,000. They also point to the proposed elimination of the estate tax in 2024, an item that won’t generate much savings and only impacts families whose estates exceed $11 million. Republicans point out that most will get some benefit, and added cash flow to corporations should help to create new jobs. Of course, neither side is listening to the other; they simply talk past each other. Those losing or facing shrinking deductions scream even if their overall taxes fall. Those benefiting the most stay silent hoping that their proposed benefits stay intact. This is why passing tax reform is so difficult.

Given that this bill has been proposed in a completely partisan manner, the odds of success totally depend on whether Republican legislators can withstand the pressure they will get from voters who appear to benefit the least. In particular, House members from high tax states will feel the most pressure. Given that there are 50 or more that fit that description, the odds are high that some modification of the proposals to cap the deductibility of taxes will be made. Of course, that means offsetting revenues will have to be found elsewhere. On the Senate side, with Rand Paul sidelined by broken ribs for some time, Republicans now number 51 and can only lose one vote. There are Republicans in both chambers of Congress who oppose the idea of an additional $1.5 trillion expansion of the national debt over the next decade. Supply side economists forecast that added growth spurred by the tax cuts will offset this cost, but there is little data historically to support that conclusion.

Note that the budget allows for an additional $1.5 trillion in annual deficits over 10 ten years, not a total deficit of $1.5 trillion. Before even considering tax cuts, the deficit today runs well over $500 billion and is expected to rise each year largely to the expansion of entitlement spending, which isn’t being touched by tax reform or the new budget. Today, in round numbers, there is about $15 trillion in net debt outstanding. The gross debt is closer to $20 trillion, but that includes Treasury securities owned by government agencies like the Federal Reserve. We now pay close to $300 billion annually in debt service. If we simply assume that over the next 5 years, the deficit averages $600 billion, that the Fed reduces its Treasury holdings by $2 trillion, and that the average interest rate paid on the Federal debt rises by just one percentage point, debt service would rise by $200 billion. If debt service cost rises by two percentage points, the increase would be $400 billion. This is not something that Congress can legislate away. It is also something that simply can’t be ignored. If we run $1 trillion deficits annually, we as a nation will be dependent on foreigners to buy a substantial amount of our bonds. Under $400 billion, the growth in savings domestically can come close to matching the rising debt needs of the nation. Obviously, as the deficit gets larger and larger, at some time in the future there will be a tipping point when the cost to borrow will become unbearable and a crisis would ensue. Think about what Greece has been going through.

Now, of course, that event isn’t just around the corner. But it does lie within the visible future if deficits are allowed to get out of control. Earlier, I suggested the need to deal with a $200 billion or greater annual addition to the deficit. The answer can only come from entitlement reform. Let me say in English what that means. It means those who receive benefits from the government via Social Security, Medicare, Medicaid and other welfare benefits will have to get less. That can be done in many different ways, ranging from direct cuts to means testing. But what it really means economically is that those groups who benefit most from entitlements, namely seniors and the poor, will have the cost of care shifted back to them and away from the government in some manner. It could be changes in the starting age for Social Security. It could be higher co-pays and deductibles for Medicare. Whatever. The point is that the government won’t be able to afford what it is now paying and when that becomes crystal clear (and it may require a crisis of some kind to drive the point home), the costs will be pushed back onto the backs of the elderly and poor. The only alternative would be higher taxes.

Whichever path Congress takes at that point almost certainly will invite a recession. Thus, tax reform, as defined by the House Republican proposal, carries near term rewards of lower taxes for many, but it also elevates risks that rising deficits pull forward the timing of necessary entitlement cuts. In this world, almost nothing is free.

There are good aspects of tax reform. Lowering the rate corporations pay will attract more investment to the U.S. and keep U.S. domiciled corporations home. But trying to add economic stimulation 9 years into an economic recovery is a bit puzzling. If you haven’t noticed, our economy right now (and our stock market) is doing just fine without any added stimulus. I’m like everyone else. I don’t enjoy writing checks to Uncle Sam and would be happy to write a smaller one next year if I could. But we get long expansions because we stay in balance. I can get home faster driving 90 miles per hour, but the risk of a major accident rises if I drive at an unsafe speed.

In the end, my expectation is for a modest cut in the corporate rate and a much less robust tax package. That will largely happen as Congress reacts to the outcries from home, not due to concern about deficits some years down the road. But the good news is that a smaller package just might be the best package for all of us.

Today, Lorde is 21. Joni Mitchell is 74. Billy Graham turns 99.

James M. Meyer, CFA 610-260-2220

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