October 23, 2017

All three leading indices, the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite, set new highs each day last week, the first time that has happened in over two decades. This morning, the Japanese market finished higher for the 15th day in a row. Obviously, optimism pervades.

The rise last week coincided with the passage of a budget outline by Senate Republicans that allows tax writers to carve out as much as $1.5 trillion in net tax breaks over the next decade. There has to be a compromise budget negotiated between the Senate and House to iron out differences, but the most likely and presumed outcome is that House Republicans will simply adopt the Senate budget.

A budget is not binding for anything. It doesn’t even get signed by the President. But under arcane Congressional rules, the use of reconciliation, which allows passage of economic bills that fit within the framework of a budget, can be passed in the Senate with just a majority rather than the normal 60 votes. Given that Republicans control just 52 seats in the Senate, reconciliation is the only way they can pass a tax bill without meaningful acceptance by some Democrats. Last week, investors concluded rightfully that passing a budget is a significant step toward achieving tax reform. Given that a budget is non-binding and non-enforceable, getting a budget passed is a lot easier than getting tax reform done. This Congress still has to prove that it can enact legislation and not simply approve a roadmap.

Since the impeachment of Bill Clinton by the House in 1998, Congress has become increasingly bifurcated. After Clinton we have seen a succession of two-term Presidents, first of one party, then another. Each time power changed in the White House, the new leader was met with open hostility from the opposite political party in Congress, a retribution if you will, for similar behavior against the prior administration. The one exception was 2009-2010 when President Obama was able to pass Obamacare and Dodd-Frank during the first two years of his first term with Democratic majorities in both chambers of Congress. Exacerbating the situation, gerrymandered Congressional districting after the 2000 and 2010 censuses widened the split via the election of more conservative Republicans and liberal Democrats.

Thus, one can argue that it has been over 20 years since Congress has seriously attempted to find a center via compromise. Instead, the liberal and conservative extremes, both vehemently crying “no” most of the time, have prevented the passage of much except in times of crisis (e.g. TARP in 2008 (and that took two attempts with Democratic control of the White House and both chambers of Congress). The Tea Party/Freedom Caucus, in particular, has set itself up as a puritanical protector of small government and low taxes. While it will undoubtedly support the notion of tax cuts, members are less likely to be enamored with the idea of an expanding Federal deficit and more debt.

The White House argument, supported by Republican leadership in Congress, suggests that a $1.5 trillion net tax cut over the next decade will be more than offset by higher economic growth, leading to expanded revenues. While there are intuitive arguments to support this theory, there is little historic data to support any conclusion but a very small increase in economic growth, nothing of the order that would offset such a large cut in revenues.

Yesterday, President Trump predicted that tax reform would be completed before the end of calendar 2017. Treasury Secretary Mnuchin has made similar claims. House Ways and Means Chairman Kevin Brady shares the same optimism. But let us not confuse politically biased chatter with reality. In 1986, President Reagan signed the last major piece of tax reform legislation after three years of hard work built on a set of compromises negotiated between himself and Democratic House Speaker Tip O’Neill. Mr. Trump doesn’t negotiate, at least not in the traditional sense. He tweets. This morning’s tweet could be different than yesterday’s. That isn’t to say his style won’t work. He has achieved some sort of relationship with Senate Minority Leader, Chuck Schumer, both New Yorkers with common backgrounds, that may be used later to get a bill over the finish line. But however you view the landscape, there is a lot of hard work ahead.

The biggest hurdle is finding offsetting revenue sources that will allow tax rates to fall meaningfully. The one guarantee is that any attempt to limit any deduction will receive vociferous opposition from current beneficiaries of that deduction. Thus, reducing the deductibility of state and local tax deductions will create an outcry from high tax states like New York and California. While many of these are traditional blue states strongly support Democrats, each one of these states has House Republicans. They will have a hard time supporting the elimination of the ability to deduct state and local taxes from adjusted gross income if they want to be reelected. Thus, some compromise will be needed. But every compromise means tax writers will have to find additional revenue sources elsewhere. Earlier ideas, like a border tax, are already dead on arrival. The White House may want to use aggressive economic assumptions to score the bill, like assuming tax reform will add one percentage point or more to annual economic growth, but the CBO and deficit hawks are not likely to let that happen.

October is ending. Congress goes on a one week holiday around Thanksgiving. It must have approved spending resolutions to keep the government running by mid-December. It must also approve an increase in the debt ceiling. It must resolve the dreamers immigration issue by early 2018. It needs to decide whether to reimpose sanctions against Iran. It has to deal with more aid to Puerto Rico. It has the normal list of year-end tax extensions to deal with. These are all “must-haves.” Tax reform isn’t a must; it’s a goal without a legal deadline. Thus, while leadership suggests that a deal will happen before year end, that seems like a big challenge, especially for a Congress more adept at saying “no” than getting any substantive legislation across the finish line.

But clearly, judging from market action last week alone, investors are starting to bake in some reasonable odds that a tax package can be done. Full blown tax reform a la 1986 is probably still a long shot. But the odds of getting something done are rising. That can all be blown apart by Republican infighting. Remember that we haven’t even seen anything more than an outline so far. Ways and Means won’t release its first draft until after a final budget is approved, perhaps as soon as this week. Then the fun starts. Once the details of a draft are on the table, there will be immediate pushback. Democrats will jump on any line item that favors the rich over the middle class. Victims of every eliminated deduction will send the lobbyists into the fire immediately. The key isn’t the first draft; it’s how well the Republicans can defend the first onslaught of opposition. Will they stand united or will they get picked apart? Will the Freedom Caucus be part of the battle or will Republican leadership have to reduce the scope of the bill further in an attempt to appease the deficit hawks? These are all questions for the next two weeks. By Thanksgiving, a package should either be coming together or coming apart. Markets will react accordingly.

Today, Ryan Reynolds is 41. Weird Al Yankovic is 58. Pele turns 77.

James M. Meyer, CFA 610-260-2220

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