The Trump Rally has been driven largely by the expectation that the regulatory environment will be relaxed and taxes reduced. It is not clear whether Trump’s base valued these issues above all others, but the markets signalled their approval. Until the Ryancare bill failed. Why does that matter? Politics is the art of the possible. Failure to pass the first significant piece of legislation this administration attempted makes the markets nervous that nothing beyond executive orders can be accomplished.
Does one need to reduce taxes and relax regulations? Perhaps. There is a perception that the Dodd-Frank legislation did little other than empowering lawyers and accountants and refocusing banks on their regulators rather than their customers. The EPA was perceived by many as having a similar effect on the auto manufacturers and the coal producers, and it is far from clear whether the Clean Power Act was having the impact it was supposed to.
Licensing requirements for some small businesses may have reached levels beyond their utility for ensuring customer wellbeing. Above all, financial markets like to be left alone and love to pay less tax. Trump promised both.
The Issues with Taxes
Taxes are complicated but so are most choices available to the government in an economy with $19trn in government debt.
The best article the author has read is by David A. Weisbach from the University of Chicago – A Guide to the GOP Tax Plan.
As the extract says, the paper focuses on “eight sets of issues: (i) the design of the business tax; (ii) the relative tax rates for corporations, partnerships, labor income, and the capital income of individuals; (iii) international tax issues; (iv) the taxation of financial instruments and institutions; (v) the taxation of corporate transactions such as mergers and acquisitions; (vi) deferral and the functioning of the individual-level tax on capital income; (vii) issues relating to the individual tax base such as the mortgage interest deduction; and (viii) problems of transition.”
The plan relies on a few headline ideas: (i) reducing the corporate tax rate; (ii) reducing the rate on investment income (capital gains and dividends); (iii) introducing a more consumption-based tax; (iv) introducing a border adjustment tax.
Broadly speaking, the rate reductions are supposed to come from broadening the tax base with a consumption tax and increasing the tax on imports. The problem with introducing a consumption tax is that it is perceived as regressive: the cost of things consumed represents a higher proportion of lower income taxpayers’ budgets than it does of higher income taxpayers’ budgets.
Winners and Losers
When paired with a reduction in the taxation of capital gains and dividends, which tend to accrue to higher income taxpayers, the net result makes for very politically unappealing headlines. The Tax Policy Center estimated the result of the plan would be to increase the after-tax income of the top 0.1% of taxpayers by 16.9%, whereas households in the middle and lower fifths of the income distribution would receive cuts of 0.5% and 0.4% respectively.
The problem with the border tax is the impact it would have on a very powerful retail sector. According to the excellent analysis of the US Balance Sheet (Financial Accounts of the United States), the retail sector, as measured by personal consumption expenditure, represents 70% of GDP. It is widely referred to as the primary engine of economic growth.
Accordingly, retailers are well represented by lobbyists in DC (OpenSecrets – Center for Responsive Politics). OpenSecrets records lobbying dollars attributed to retail sales of $45m in 2016. Although a small fraction of the over $3trn of lobbying dollars spent in 2016, it is reasonable to expect lobbying support on this issue from “Business Associations” ($144m); oil and gas ($118m); electronics manufacturing and equipment($119m) and automotive ($62m).
What a Border Tax Could Mean
Imports are a significant portion of retailers’ expenses (according to the US Census Bureau – Trade in Goods and Services – imports at $2.7trn in 2016 represented 22% of total personal consumption expenditures). The majority of their revenues, however, are domestic. The impact of a border tax would be dramatic. An example will help. Assuming $95 of import costs on a domestic sale of $100, a retailer makes $5 of economic profit and would, at a 35% tax rate, pay $1.75 of tax for a net profit of $3.25. In a regime where the corporate tax rate is reduced to 20%, but where the border tax adjustment disallows the deduction of import costs, the $95 of import cost may not be deducted, and the retailer’s taxable profit is $100. This would attract a tax of $20, which is 4x the retailer’s profit.
The theoretical, economic explanation for why this should not be a problem is as follows: (i) exports are not subject to tax and accordingly $100 of export sales would be tax free to a US exporter; (ii) US export goods would become more attractive and their price would rise; (iii) the price adjustment would result in a currency adjustment and the dollar would appreciate in value; (iv) this currency appreciation would tend to make exports less competitive and would reduce the cost of imports; (v) since currency markets are deep and liquid, the reduction in import costs ought to compensate very closely and quickly for the lack of tax deductibility of import costs.
Retailers are unlikely to be persuaded and, at a minimum, the transition could be painful. There are technical problems also concerning countries whose currencies are pegged to the dollar and because certain significant import items – oil primarily – are priced in dollars. Clearly, there are many OECD economies who have a consumption tax in the form of a value-added tax (VAT), where the economic adjustments have been made. That argument is also unlikely to persuade retailers.
There are other aspects of the plan that are complex. A movement to a consumption-based tax framework emphasises a cash-based taxation system where assets are expensed rather than depreciated. This potentially removes vast areas of the tax code devoted to tax basis and depreciation. Simplification is good and saves money. However, the current plan does not permit the expensing of land, which means, for the time being at least, the concepts of basis and the associated tracking mechanism will remain. It appears also that inventory accounting will remain.
Taxes vs. Lobby
Weisbach’s paper details a number of other problems concerning financial flows, the treatment of interest expense and the different treatment of ‘some amount’ of mortgage interest (perhaps a concession to the $103m of real estate industry lobbying dollars). It is worth a read for those with a particular passion for tax.
The likelihood is that the majority of the press, the general public and, if the complexity-appetite of the majority of Congress demonstrated during the recent consideration of the Obamacare repeal is a guide, the majority of politicians (and the president) will not get past the regressive nature of a consumption tax and the strength of the retail lobby. The swamp will continue to fester.
The country needed a vastly more bi-partisan approach to healthcare reform. Tax reform is even more complex and, while arguably more aligned with a broader cross-section of the Republican Party, has very little chance of receiving due consideration and, ultimately, little chance of being implemented. The Treasury Secretary has recently admitted that his aspiration is more modestly focused on a small reduction in the individual rate. That will not move the needle for the economy.
It is not clear how this story will develop, but the markets had better look elsewhere for the stimulus they had hoped to see from tax reform.