September 29, 2017

Stocks rose to new record highs as investors reacted positively to the Republican tax reform proposals.  Interest rates also rose but gave up most of their gains in the afternoon.

After the November election stocks took off, anticipating stronger economic growth in a Trump Presidency.  It was presumed that some portion of his agenda would become law relatively quickly, given that Republicans would be in control of the White House, and both chambers of Congress.  But, as we have learned, getting campaign proposals converted into the law of the land hasn’t been so easy.  Many of the early winners, whose gains were most tied to higher growth, more inflation and lower taxes, spent most of 2017 giving back their gains of November 2016 to February 2017.  However, the eight page outline introduced Wednesday, plus a lot of enthusiastic jawboning by President Trump and House Speaker Ryan, gave investors some encouragement that the failures surrounding health care reform won’t be repeated.  Treasury Secretary Mnuchin said last spring that tax reform would be done by August.  Recently he repeated that forecast, but pushed back the timetable to December.  Yesterday, Speaker Ryan reiterated that forecast.

Don’t bet the ranch.

Let’s just step back for a moment.  As members of the investor class, there is a lot to like in the proposals.  Corporate tax rates will go down.  Pass-through rates for S-Corps and other limited partnerships will go down as well.  Overseas profits will be able to be repatriated at a low rate.  The top personal income tax rate would come down.  The standard deduction will be doubled.  Alternative minimum tax rules will be eliminated, as will the estate tax.  What’s not to like here?

But now look through the eyes of a middle class American family living in upstate New York.  The lowest tax rate is being raised from 10% to 12%.  I realize that might be bad optics because the starting point may be different, but whoever inserted that rate increase into the 8-page outline really wasn’t thinking.  The personal exemption is to be eliminated.  The ability to deduct state and local taxes is also gone, the biggest way this proposal is going to pay for all the goodies.  That won’t sit well in New York or any other state with a lot of local taxes.  New York, California, and Illinois, all high tax paying blue states, have 30 Republican members of Congress.  If they want to be re-elected, each is going to have to fight very vociferously to retain the deductibility of state and local taxes.  I understand perfectly the argument that under today’s tax code those states that pay no state taxes subsidize the states that do pay high taxes.  But the tax code isn’t about fairness; it’s about each of us paying not a dime more than we need to.  This is just one example of why full blown tax reform is so difficult.

Let us also note that this proposal was created by six high-ranking Republicans with the President’s blessing.  There was no Democratic input.  Even if some important Democrats were kept informed, they had no input into the plan.  Speaker Ryan, despite failing repeatedly with Obamacare repeal and replace, believes once again, that going after tax reform on a purely partisan basis is the right roadmap to victory.

We all know that, politically, the Republicans will disadvantage themselves if they go into next year’s mid-term election without a significant victory of some kind.  They can whine about lack of Democratic support, but with control of the White House and both houses of Congress, such a complaint won’t sit very well.

From an investor perspective, i.e. what’s good for business is good for stakeholders, a cut in the corporate tax rate, the ability to repatriate earnings from overseas, and, perhaps, a bill to increase infrastructure spending would seem both palatable and non-objectionable.  But polls show that the average American doesn’t want a cut in corporate taxes.  They simply don’t see the connection between such a cut and their wallet.  You and I might see it, but they don’t.

So, what happens from here?  First of all, true tax reform is hard.  It takes strong leadership, both in Congress and the White House.  It requires a willingness to compromise.  It probably requires some level of bipartisanship.  There is no monolith called the Republican Party, and while Republicans have majorities in both the House and Senate, they don’t have cohesive working majorities in either.  The need to pass something could pull them together on a much smaller package of basics but not anything like what we just saw put on the table.

All Presidents have their wish list.  Every year, President Obama presented a wish list, and in eight tries he never got a budget passed.  Therefore, let’s look at some of the key points and assess their chances of becoming law.

Corporate

  • Lower corporate taxes – Possible but forget 20%, especially if Republicans have to give in regarding eliminating some deductions. Obama wanted 28% with so many offsets that it would have been an overall tax increase.  28% seems possible.  Some will note that the average Fortune 500 company already pays less than 28%, but that is because it pays so much less overseas.  A cut to 28% wouldn’t be a home run, but it would be a nice kicker.
  • Repatriation of offshore earnings and a low one-time cost and shift to a territorial tax system – If anything is passed, this one seems obvious. Most likely, however, there will be a link between repatriated earnings and the need to increase investment spending.  Repatriation to pay dividends to shareholders won’t be looked at positively by most.
  • Immediate expensing of new investments – Probably, again only within an overall package.
  • Reducing the pass through rate to 25% – Won’t be necessary with a 28% corporate tax rate. Certain pass-through provisions will be eliminated.
  • Eliminating current corporate deductions – Something has to be done to pay for the lower rates.

Individual

  • Lower the top rate from 39%+ – Not going to happen; if anything, it will be raised.
  • Eliminate most itemized deductions except charitable giving and mortgage interest – Again, there will be no tax cut for the middle class without eliminating some deductions.
  • Eliminate the personal exemption – Probably not.
  • Double the Standard Deduction – The concept will sit well with all. Millions more could file simple returns.  But this is a costly move that has to be paid for.
  • Eliminate the estate tax – Republicans would like it, but this isn’t important enough to fight for.
  • Repeal AMT – This would also be an expensive item that has to be paid for. Everyone hates it, it hits the wrong set of people it was intended to impact, and it complicates the preparation of returns and tax planning immensely.  Rather than repeal, it should be modified to hit those ultra-high earners for which it was originally intended.  By the way, most of those high earning execs from New York, et al end up losing the deductibility of state and local taxes (including real estate taxes) because of the AMT.

If Republicans in the House try to go this alone, I believe they will fail.  Between Representatives of high tax states and those who want deficits and debt to fall, they simply won’t be able to get enough votes to get anything near what was proposed Wednesday to pass.  Given the repeated partisan failures to get healthcare reform passed, President Trump is not going to have any patience with Speaker Ryan and the House not getting something through.  At the first hint of failure, he will turn to the Democrats and get them involved.  You can make your own judgment of the political merits of such a move but if there is going to be any tax package, Democrats have to be part of the process.  Trump has already reached out to several key Democratic Senators and gotten their input.  He wants to find bipartisan common ground.  The question is whether there is such a thing.  Time will tell.

The odds of anything getting done this year are negligible.  The odds of anything getting done next year are 50:50 at best, and whatever might pass will be a stripped-down version of what we saw on Wednesday.  As soon as the roadblocks start appearing, the gains of the last two sessions (and they weren’t all that much) will likely get reversed.  The good news, however, is that the economy continues to grow, inflation remains non-existent and the dollar is favorably valued.   From mid-October to the end of the year is normally a very strong seasonal period for stocks.  Obviously, with all the gains year-to-date, expecting equally robust performance in Q4 might seem optimistic.  But stocks go down because there are more sellers than buyers.  Money grows, earnings grow and bonds still appear unattractive.  All that suggests more of the same isn’t such a wild dream.

Today Kevin Durant is 29.  Jerry Lee Lewis is 82.  There will be a whole lot of shakin’ going on.

James M. Meyer, CFA 610-260-2220

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