Will Disappointing Tax Reform Puncture the Stock Market Bubble?

Based on what top tax experts are saying now, the heavily hyped Trump tax reforms are likely to turn out to be a big dud. Given the overextended state of the stock market, could this wind up being the trigger for what many market commentators see as a long overdue price correction?

More and more market mavens, such as John Mauldin and strategists like former central banker, now Citigroup’s chief economist Willem Buiter, have been raising red flags about valuations in the US stock market and in Buiter’s case, investment prices generally.

Most commentators are looking nervously for a Big Event to take the air out of inflated asset values, such as a financial crisis in China that the government can’t contain, or central bankers tightening too quickly or bond prices sinking more than anticipated when the Fed starts shrinking its balance sheet. But could an underwhelming tax reform bill finish off the undue optimism about what
a Trump presidency could do for the economy?

Why the Tax Reform Bill Will Probably Disappoint Tax “Reform” Fans

Rest assured that the Republicans will pass a tax bill. First, Republicans love cutting taxes. Second, after the Obamacare reform disaster, Republican need to be able to point to an accomplishment, so getting tax reform done is a top priority.

However, the Republicans have a big obstacle to achieving their objective. Most Republicans and many Democrats are deficit hawks. So that means any tax cuts need to be matched with either spending cuts or tax increases elsewhere.

The problem is that the Federal spending as a percentage of GDP is already low by world standards, as you can see by the terrible state of a lot of our infrastructure, some of which is Federally funded, like Federal highway and bridge repairs. So we actually don’t have a lot of places left to cut, save the sacred cow of our bloated and overpriced military. 1

One of the tells that Republicans have limited tax cutting room is that no one has even mentioned a perennial Republican favorite: cutting capital gains taxes.

Below, I’ll flag a few of the tax reform items in play and describe where they appear likely to go. This is based on the work of top tax expert Lee Sheppard, including her overview in Forbes, which covers more of the tax issues in play, and a panel at NYU. Keep in mind that the recent comments in the press by Administration figures like Steve Mnuchin and Gary Cohn are pretty consistent with her reading.

Popular but not as big a deal as you’ve been told: overseas profits tax holiday. The Bush Administration gave companies that had parked profits overseas a one-time repatriation at a reduced rate in 2004. That will happen again, and it will not be voluntary. Companies like Apple that have profits stashed in offshore entities will get a bill. So this will help pay for some cuts elsewhere.

However, despite all the media hysteria about this issue, the impact will be limited. First, only a few sectors, such as Big Pharma and tech firms, made use of this structuring gimmick. Second, this holiday affects reported profits, not actual cash. As we’ve mentioned repeatedly, Apple’s overseas profits sit in New York banks and are managed as an internal hedge fund out of Nevada. The media has repeatedly taken up the bogus talking point that these noble companies were being denied the opportunity to invest in the US. Help me. Third, as we know from the 2004 tax holiday, the profits repatriation will go to executive bonuses and dividends, not to investment.

Moreover, because this measure has been so widely anticipated, the actual passage may not do all that much for the stocks of the companies that benefit.

Likely big disappointment: reduction in corporate tax rates. Yes, the Republicans will reduce the overall corporate tax rate and get rid of some loopholes. But recall that they need to find revenues, as in getting rid of loopholes, or cut expenditures, to fund a corporate rate reduction. And as we’ve warned, every loophole has a constituency.

Trump talked about reducing the corporate tax rate to 15%. Na ga happen. In his interview with the Financial Times late last week, Gary Cohn suggested 22% to 25%. Sheppard, who has a very solid track record on calls like this, expects the final number to be 29%. For all the fuss and handwaving about corporate rate reduction to only get to 29% when the average effective rate is now 25% is going to make a lot of Republicans unhappy, above all small businessmen who have fewer options for playing clever tax reducing games than big companies.

Widely ignored small to medium sized negative for capitalists: limiting corporate interest tax deductions. In the face of a more modest-than-expected reduction in headline tax rate, the rollback of pet deductions will rankle more. One that is slated for the chopping block is the deduction of interest expenses. Small business and banks will presumably get a waiver, but big companies would find their deduction limited to net interest expense. However, could some get back largely to status quo ante by using clever financial instruments or trading strategies to recharacterize what would have been interest income as some sort of short term trading profit?

Dinging high salary earners: ending state and local income tax deduction. Keep in mind that the real action on this tax bill is on the corporate side; the dollars involved in the rejiggering on the personal side will be relatively minor.

Nevertheless, Trump has promised middle class tax cuts. Keep in mind that i terms of “where do you get the money?” taxpayers broadly fall into four categories: those who pay no income taxes (bear in mind they pay sales taxes and property taxes through rents), now down from Rommey’s 47% to 44%; the middle class, which is people whose household earning $50,000 to $100,000; the high salary group, like top professionals and corporate executives who make over $100,000 a year, and the really rich, whose income comes mainly from capital gains.

The problem is that the middle class pays a lot of tax in aggregate but the amount of tax collected proportionately is already low by world standards. So there’s not a lot to cut here and the Trump tax reduction is likely to be add up to maybe a few refills of gas. But even to pay for a largely optical tax cut, more had to be taken from where it can be had, and that’s the high salary group.

The Republicans no doubt think their idea of getting rid of the state and local tax deduction is oh so clever because it will hurt high tax blue cities particularly hard. But many of the people in those locations already had their deductions limited by the alternative minimum tax.

Keep in mind that this change will hit communities with high property taxes, and not all of those are in or near blue cities, but also include other affluent suburbs. Now perhaps this move can also be seen as another bit of Republican social engineering, to make paying for property taxes, which go largely to funding public schools, even less popular. And of course, ending the property tax deduction should have an impact on home prices in affluent communities, which will affect not just homeowners but brokers. So expect to hear some whinging when more people focus on this part of the tax plan.

As indicated, Sheppard describes the other major expected changes. The biggest that I’ve skipped over is changing from world-wide taxation of corporate income to a “quasi territorial” system. While this will simplify tax computation, it will also get rid of some gimmicks, so that net this isn’t much of a gimmie. Note I’ve also skipped over the elimination of the carried interest loophole, which the Administration is also walking back, as in winking and nodding that it might continue in some cases (hedgies are likely to lose it, the supposedly sacred venture capitalists will argue the necessity of creating yet more apps and fake unicorns mean they deserve special treatment, and the super powerful private equity types will also try to depict what they do as virtuous). The reason is that even though it is a political hot button, it does not add up to a lot of tax dollars.

Will an Overhyped Tax Reform Bill Give Mr. Market a Sad?

The short answer is “Who knows? Markets are fickle and moody creatures.” But the US equity market is primed to have some, and perhaps a lot of air let out of it. And the events that have that sort of impact are often ones not widely anticipated. Tax reform falls in that category. Despite the financial press dutifully reporting on the high points of the tax reform wrangling, tax is such a MEGO (My Eyes Glaze Over) topic that from what I can tell, most financial market commentators are still talking up the hype and are considerably behind the state of play.

Recall that big stock market downdrafts can occur simply when an overextended market registers information that finally dents investor confidence enough to lead to selling. For instance, the spectacular 1987 crash was set off by seemingly minor events. The Brady Commission report said that the selling was triggered (its word) by an unexpectedly large trade deficit which pushed interest rates higher and the proposal by Treasury to tax highly-leveraged transactions at a higher rate.

So why might an underwhelming tax reform bill have broader implications? Remember that Smart Money thought that a Trump win would be bad for the stock market, then dramatically changed its mind when the votes were tallied. The post-election rally and continued optimism seems to have been based on key interest groups believing that Trump would deliver on promises that were believed to be capable of stimulating the economy, such as more infrastructure spending and for the supply side crowd, tax “reform” meaning cuts.

Even though small business and consumer confidence measures are high, it turns out small business confidence is an terrible predictor. And despite consumer confidence supposedly being robust, it hasn’t shown up in consumer spending. Nor is this supposedly buoyant attitude matched by their income expectations. As the Financial Times explained why in May (emphasis original):

Deutsche Bank’s Torsten Slok points out that the improvement in expectations is entirely due to Americans without a college degree, rather than those with greater spending power and higher earning potential. Americans with degrees have been getting steadily less optimistic since mid-2015…

Slightly less dramatic, but nevertheless revealing, is the change in expectations among younger people, who have their most productive years ahead of them, relative to older people, who do not.

Since the start of 2015, the outlook among the young has deteriorated sharply, albeit from a high base. Meanwhile, the expectations of Americans ages 55 and older have soared in the wake of the election to their highest level in more than fifteen years.

It isn’t uncommon for stock prices to be out of whack with fundamentals. But there will be at least two takeaways from a soggy tax reform bill. One is that the supply side cranks won’t get their tax stimulus. Even though this idea has long been discredited, it still has an unwarranted following among equity analysts. Second is that there won’t be any real stimulus either thanks to the preponderance of balanced budget fetishists on both sides of the aisle. Third and potentially the most important is that a tax bill belly flop may finally lead businessmen to recognize that even control of the Executive and Congress, the Republicans are unable to deliver them their hoped-for goodies.

1 Aside from the fact that the US cannot go bankrupt in its own currency and therefore should be worried about real resource constraints rather than accounting, another reason the “balanced budget” debate is a huge headfake is that any “balanced” budget inherently won’t be. There is always plenty of money for any and every military misadventure, like the next bombing run in the ‘Stans. Some of the black budget has been formalized as “Overseas Continuing Operations.” That sits outside the official effort to make the revenue and spending numbers match up.

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