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Aon Retirement and Investment Blog

Trump Tax Plan 2.0: Fiscal Policy Turns From Drag to Tailwind?

The Republican leadership resurrecting the Trump tax cut plans has meant that stimulatory fiscal policy is back on the agenda. However, it is not just the US where the prospects of much looser global fiscal policy have increased over the last couple of weeks. The German election result and early Japanese elections have made the global fiscal stance likely to be a lot looser. While it is too early to say that plans will definitely be delivered upon, what could have been a drag for the global economy in 2018 could yet be a tailwind.

Trump Tax plans are Resurrected

While widely referred to as the “Trump Tax plan,” the plan has been crafted by a group of top policymakers from across the Republican Party, known as “the big 6.” Treasury Secretary Steve Mnuchin and National Economic Council director Gary Cohn are the key architects, but they also have had to get buy-in from Congress. The other four key players are Senate Majority Leader Mitch McConnell, Senate Finance Committee Chair Orrin Hatch, House Speaker Paul Ryan, and House Ways and Means Committee Chair Kevin Brady. The key proposals are:

  • a cut in corporate tax rates from 35% to 20%
  • a simplification of the federal personal income tax bands which will see the top rate brought down to 35%, but at the bottom, the $0 to $9,325 income band will be raised to 12% (from 10%)
  • an elimination of estate taxes and the alternative minimum tax
  • a temporary period of allowing depreciable capex to be fully deductible in year one to boost investment, with a partial repeal of interest deductibility
It is the prospect of corporate tax rate cuts which has excited markets and propelled the S&P500 to new highs. The US tax rate is generally recognised as being uncompetitive, with the combined State and Federal level making US corporate taxes the highest in the OECD.

Fig 1. US Corporate Taxes are the Highest in the OECD

Although effective tax rates were much lower, this high rate on domestic profits was seen as driving corporate inversions, where companies would move their tax jurisdiction to other countries.

There are plans to boost immediate revenue with a one-off tax on existing profits held overseas. However, the plan also suggests a global tax will be introduced:

“by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations.

Such a move would likely still encourage companies to domicile overseas to prevent their non-US profits becoming subject to US taxes.

Bad for Debt. Good for Incentives.

As Harvard economist Martin Feldstein, one of President Reagan’s chief economic advisors, puts it: the plans means that “The debt is moving in the wrong direction. But the tax reform is moving in the right direction.” Steve Mnuchin claims that the boost to incentives will mean that economic growth will be faster and consequently the adverse impact on debt will be minimal, but he will need to convince the fiscal conservatives in Congress to get the plans passed. The Congressional Budget Office is unlikely to concur, and this will mean that some modifications of the plan will need to be made in order to get the proposals through Congress. One possibility is elimination of the “SALT” (State and Local Tax) deduction. This enables households to deduct their state and local income taxes from their income for Federal tax calculations. This would raise $1.3 trillion over the decade, predominantly from Democrat leaning states according to the Tax Policy Centre (TPC). While some modifications seem likely, we believe that with one-eye on the mid-term elections, there will be a much greater desire for the Republican party to show some unity and deflect from what has been a somewhat chaotic eight months for the administration. The overall impact according to the TPC is that revenue will be reduced by $2.4 trillion over the next decade. The Senate proposed last Friday that the top-line debt shouldn’t be increased by any more than $1.5 trillion over 10 years. We believe both sides are motivated towards getting a deal where the fiscal debt increase ends up being between these figures.

Will the Border Adjustment Tax Morph into a Value Added Tax?

The Border Adjustment Tax (BAT) was a proposal to make US corporate tax a destination-based cash-flow tax and was one of the most controversial parts of the original Trump tax agenda. This would have meant that imports would no longer be a tax deductible cost and exports would no longer count as revenues. However, the plan generated a huge amount of opposition from retailers and companies which outsource their production overseas and was abandoned in July. However, it did have the advantage of raising a lot of revenue.  While we don’t think that the BAT in its previous form will necessarily be resurrected, there may be an increased focus on replacing corporate taxes with a Value-Added Tax (VAT), which would bring the US into line with other OECD countries. VATs are effectively a tax on consumption, and this would achieve many of the objectives of the BAT but would not generate the same level of opposition from abroad.

Modest Growth Impacts?

Does this mean economists will be revising up their 2018 GDP forecasts? Tax cuts boost aggregate demand in the economy by leaving both households and firms with more money to spend. They can also have supply side effects, as the productive capacity of the economy is enhanced by improving incentives and reducing the distortions that taxes create. Goldman Sachs argues that the impact on growth will be fairly modest. Goldman assumes a $1 trillion stimulus over 10 years leading to a 0.5% boost to the growth rate by Q3 but then fading thereafter.

Fig 2. Trump tax plan’s Boost to Growth?

The End of Schaublenomics?

The prospect of easier fiscal policy is not just limited to the US. German finance minister Wolfgang Schauble, has been the main casualty of Angela Merkel’s weak performance in the German Bundestag Elections. Schauble has been the main bulwark against looser fiscal policy both in Germany and across the Eurozone. Whoever the new German Finance Minister is, they are unlikely to have the same appetite for fiscal prudence as Schauble has done. Christian Lindner – leader of the Liberal party (FDP) or his deputy Wolfgang Kubicki might take the post.

Not only might this mean that Germany will move to a more expansionary policy but, together with Emmanuel Macron promoting a pro-growth agenda for Europe, the whole Eurozone could see easier fiscal policy.

The Japanese elections will also likely postpone plans for fiscal consolidation in Japan. Last week Tokyo Governor Yuriko Koike launched a new party – Party of Hope – which means that Abe’s victory is no longer a certainty. While it is not clear if she will run herself, some competition will mean that the ruling LDP party is likely to tilt towards promising tax cuts in order to win support.

Implications for Markets

What does this mean for investors? We believe:
  • At the margin, the Trump plan should be a bit more supportive of the dollar. If passed, more fiscal policy stimulus will likely mean that the Federal Reserve will have more of an incentive to tighten. 
  • However, as other countries are also shifting towards stimulus, it is not obvious that this change will translate into significant dollar strength, though the recent recovery in the US dollar could have a bit further to run.
  • Overall, if additional stimulus does come through in this way, the main impact would be to strengthen the trend towards rising yields.  Of course, there are still uncertainties on how much stimulus comes through and when, but it is something we are watching to see if this starts to strengthen our currently mildly negative duration view on global bond yields.
  • Our base case is that rates will rise only slightly more quickly than priced into markets. However, if there is less spare capacity in markets than thought and inflation takes-off at the same time as fiscal stimulus comes through, bond yields could rise far more rapidly.
  • For the time being, the expected small boost to growth is supportive of global equity markets and risk assets. Provided the rise in bond yields is slow, this should encourage investors to rotate out of fixed income and in to equities. However, if the rise in yields was to become disorderly, there would likely be adverse impacts on equity markets.
Derry Pickford is a Principal on Aon Hewitt’s Global Asset Allocation team, and is based in London, UK.

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