The substance, if not always the tone of Donald Trump’s “America First” pitch for the US presidency, was largely about jobs and growth, and this agenda remains the main criteria by which most voters can be expected to judge his success. In terms of delivery, nothing is likely to prove more decisive for his term in office than how effectively his tax policies play out for the US economy over the next four years.
His administration’s approach could best be characterised as a version of Ronald Reagan’s supply-side economics, relying on tax cuts for businesses and for individuals to stimulate investment-led growth. By providing strong growth, the theory goes that any decline in government tax revenue due to these policies will be offset by the income generated from increased economic activity.
Markets have a lot riding on Trump’s stimulatory tax policies. Their impact on the US economy will determine whether equities can sustain current valuations or advance to new record levels. The performance of bonds and the dollar will meanwhile depend on the effectiveness of President Trump’s tax policies at generating growth without also sparking inflation and an accelerated pace of interest rate hikes from the Federal Reserve.
Under the proposal, personal income tax cuts would account for three-fourths of the reduction in government tax revenue. These would involve a combination of across-the-board cuts for individuals, the elimination of federal estate, gift and generation-skipping taxes, a repeal of the Alternative Minimum Tax (AMT) and a simplified tax structure. Trump proposes to reduce the number of tax brackets from seven to three and lower the bracket for top earners from 39.6% to 33%. Another important feature would be a large increase in the standard deduction provision and limits on itemized deductions and other preferential treatments.
Corporate income taxes under Trump’s tax plan would also undergo a far-reaching restructuring, most notably by way of the introduction of a border-adjustment tax (BAT). The idea is to lower the current national tax rate of 35% to 15%-20% by removing export sales from a company’s taxable revenue and instead apply a BAT to imports that are consumed within the US.
This approach is designed to stop multinationals from relocating their legal domiciles to low-tax nations, a practice known as a tax inversion, and to otherwise stop sheltering overseas profits from US taxes, which is currently accomplished by shifting intangible assets to low-tax nations. It would create a windfall for the government, though it could also trigger tariff wars with trading partners.
Shifting the tax burden to imported goods is designed to incentivize US companies to invest in domestic production and to strengthen the dollar, potentially by an estimated 25%. This, in turn, would help to keep consumer inflation at bay, even if foreign producers increase prices to cover the higher import taxes.
Three other notable features of Trump’s tax plan for businesses include the repeal of the corporate AMT, the elimination of most tax breaks for businesses and a sharp reduction in taxes that apply to pass-through income. Pass-through income refers to income that individuals receive from businesses other than corporations which they claim on their individual tax returns. Currently, the top rate that applies to high salaried individuals for this is 39.6%. But this would also fall to 15%-20% under the Trump tax plan, providing a potentially huge windfall for high earners as well as reducing the government’s tax take.
Where the government’s tax take will fall is a matter of critical interest for the market and the economy. Achieving Trump’s stated goals, which include providing middle-class tax relief and boosting economic growth without adding to the debt or deficit, are already widely being questioned – even before his proposals are presented to Congress.
Balancing the Books
The Tax Policy Center estimates the proposals would reduce federal revenue by $9.5 trillion over the first decade and an additional $15 trillion over the subsequent 10 years, excluding added interest costs or macroeconomic feedback effects. The additional interest on the increased level of national indebtedness alone would balloon to an estimated $1.6945 trillion in the period from 2016 to 2026.
While the measures would reduce the average tax bill by about 7% of after-tax income, the highest-income 1% would see their average tax bill cut by over $275,000, or 17.5% of after-tax income. Whether tax relief to businesses under the Trump tax plan results in higher domestic investment, growth, job creation and incomes is also questionable at a time when US unemployment is at 4.7%. Most of the new jobs that will be created will also require skill sets that many of the currently unemployed will be unable, or unwilling to retrain to fill and the president’s restrictions on new immigrants is likely to exacerbate the skills shortage.
The Risks Ahead
The president’s tax policies could also prove highly inflationary as tight labor markets drive up wages. This is already starting to worry the Fed, which has raised its Fed funds lending rate twice in the past year and has plans to continue raising it to prevent further inflation from developing.
The main risk to bondholders comes from the possibility of an accelerated pace of interest rate increases, which causes their prices to fall. There’s also risk from inflation, which erodes the purchasing power of proceeds. Beyond these, Trump’s suggestions during the campaign that he might try to negotiate with creditors rather than pay interest on the government’s debt raises the prospect of a default, which carries dire consequences for holders of government debt, for America’s credit ratings, the dollar and the economy.
Market expectations from Trump’s ability to deliver are high. Equity market indices have repeatedly reached new records since his election, suggesting a lot of faith in his ability to fulfill his campaign promise to lower corporate tax rates and put more tax savings into people’s pockets. Adoption of the controversial BAT appears to be largely priced into current equity valuations, despite little evidence of progress towards its passage in Congress. This leaves the market open to potential disappointment – particularly in shares of the large multinationals that stand to benefit most from its passage – should the proposal be rejected.