US tax reform: Weighing up the impacts
The fiscal stimulus comes at a time where we have monetary tightening from the Federal Reserve combined with a global upturn in growth and trade volumes. This mix will mean the full effects of the reform will take months to play out. US markets priced in the tax cuts throughout 2017, however, comparisons to the effects of Reagan’s 1986 tax cut on the markets are difficult to make, given that we face very different equity valuations.
The headline announcements of the plan were as follows:
1) Corporate taxes being cut from 35% to 21% (albeit the effective rate is higher given the need for state tax inclusion)
2) The 100% depreciation allowance for capital investments for the first five years only
3) Interest deductibility being limited to 30% of EBITA from 100%
4) The introduction of a territorial tax system for corporates to discourage them from moving income out of the US in the future
5) Tax cuts for each of the seven income brackets, with provisions set to end in 2025.
The repatriation clause, which was a factor in the US dollar strength after the 2016 election, now has a more mixed outlook.
Corporates face two different rates for repatriation flows
The higher rate (15.5%) applies to “cash positions” and the lower rate (8%) applies to permanently reinvested earnings (PRE), which covers dollar-based financial assets. Importantly, firms can select to pay their obligation, which will now be taxed whether it is repatriated or not, over an eight-year period. The option to pay 8% of the obligation in each of the first five years will essentially back-load their payments. This design, combined with a high proportion already being US dollar denominated, would limit any repeat of the strength seen after the 2004 repatriation tax holiday (5.25% vs 34%).
Personal income tax cuts and corporate investments
Consumer spending over the next two years will be positively affected by the personal income tax cuts. The biggest impact will be seen in 2019, since most of the tax reductions will not show up in consumers’ pockets until the tax returns for 2018 are filed in 2019. The size of the overall multiplier from the individual tax cuts may be muted overall, given the 2.7 percentage point drop in the personal savings rate from 6% two years ago. Also, the cuts are skewed towards higher-income tax payers, who generally have a lower marginal propensity to consume any additional income.
The additional impulse to investment kicks in with a lag around mid-2018, with the 100% expensing of capital investments encouraging a front-loaded approach. However, current estimates are that only 35% of originally planned investments will be brought forward. Disincentives from other areas of the package, such as discouraging the use of debt financing relative to equity financing, could also limit any large increases in investments that the administration hoped for.
Impact on national debt
The tax reform injects additional exuberance into a late cycle economy, which is seeing its third longest post-WWII economic expansion. This, combined with higher debt levels and a tightening Fed, will lower economic multipliers. The other key concern is the impact on the country’s deficit in the medium term, given that it will add another $1.5tr to the deficit over a 10-year budget horizon, 45% of which will be front-loaded during the first three years.
Overall, there is cause for optimism in the near term, given the front-loaded nature of much of the package. However, questions remain on whether the package will come at the cost of substituting a burst of short-term additional growth in a late cycle economy, while simultaneously removing an option which would have helped tackle any slow-down in the future.
Looking forward past the tax reform
The infrastructure plan will need a bipartisan agreement, and the administration will need to decide whether it moves to focus more aggressively on the trade front, given the limited actions up to now barring the ongoing North American Free Trade Agreement (NAFTA) renegotiations. A win in the latter could be supportive for the Republican Party campaign going into the mid-terms in November. For infrastructure, the success of the programme could come down to whether the party is able to successfully pass the first gas tax hike since 1993 to help pay for it. In recent weeks, there has been an increase in the tone and the frequency of discussions regarding trade, with the first step being the early issuance of the report from the US Trade Representative into unfair trade practices by China.
After the tax cut plan, we continue to favour non-US equity markets on valuation grounds, while within the US we have a strong preference for the energy sector. We remain positioned for US dollar weakness against selective G10 and emerging market currencies. We expect that the largest source of repatriation conversion will be the euro with the currency negatively impacted, given that the distribution of offshore profits is heavily skewed to the eurozone. However, it is the timing of the flows, which we expect will be in stages, that will limit the near-term impacts on the pair.
Samed Hysa is a macro analyst at Ashburton Investments