US tax package: a look under the bonnet

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The Trump administration’s late 2017 tax package seeking, among other measures, tax cuts for US businesses and households, may be a feather in the cap for Republican politicians, but from an economic perspective, we believe the negatives – which include a boost to the fiscal deficit – are likely to outweigh the positives.

The tax package secured Congressional passage despite opposition both from fiscal conservatives troubled by the likely impact on the deficit and from moderates wanting to ensure that middle-income households would benefit from the tax cuts. Here are the details.

On the corporate side, the main components of the tax package are:

  • A projected increase in the deficit over the next decade of USD 1.4 trillion after allowing for dynamic growth effects
  • A reduction in the corporate tax rate from 35% to 21%
  • An immediate tax on retained offshore profits, set at 15.5% for liquid assets and 8% for illiquid assets
  • A 20% deduction applied to income from pass-through corporations, effectively generating a top tax rate of 29.6%
  • Immediate deductibility of business investment expenses for five years, tapering thereafter.

On the personal income side, the main changes within the tax package are:

  • A doubling of the standard deduction for joint income tax filers to USD 24 000, although personal exemptions are repealed
  • The imposition of a USD 10 000 cap on deductible state and local income and property (SALT) taxes
  • Mortgage interest deduction is maintained but limited to mortgages of USD 750 000 or less for new mortgages
  • A doubling of the child tax credit, with higher phase-out limits
  • New income tax brackets and rates, with the highest rate falling to 37% from 39.6%
  • New brackets for the Alternative Minimum Tax (AMT), meaning that far fewer households will pay the AMT
  • Repeal of the Individual Mandate that requires individuals to purchase health insurance
  • A doubling of the federal estate tax exemption to about USD 10 million per individual.

From an economic perspective, the tax package is likely to have these effects:

  • Higher after-tax corporate earnings should boost equity valuations, supporting consumer confidence and lowering the cost of equity financing for companies
  • Companies will likely repatriate overseas profits immediately, which could be used for a mix of business investment, dividend payments, stock buy-backs, mergers and acquisitions, higher wages or lower product prices
  • Companies will likely repatriate foreign profits immediately, which could be used for a mix of business investment, dividend payments, stock buybacks, mergers and acquisitions, higher wages or lower product prices
  • Individuals should be incentivised to reclassify themselves from wage-earning employees to ‘pass-through’ corporations to take advantage of lower tax rates
  • A reduced income tax burden should increase disposable income (particularly among higher-income earners) and provide a slight boost to consumer spending
  • The reduction in allowable deductions for SALT and mortgage interest payments reduces the tax subsidy to home-ownership, thus likely having a marginal impact on prepayment speeds and hitting property values in high-tax states.

In the near term, this tax package delivers considerable benefits to companies and high-income individuals, while generating higher future deficits (as scored by the Congressional Budget Office). As a result, we now forecast a fiscal impulse to growth of about 0.25% of GDP in both 2018 and 2019.

Is this a good tax package for the US economy?

In our view, on balance: No. That said, we would not deny that there are some constructive aspects to the legislation.

  • First, capping state and local taxes helps to reduce the distortion whereby the federal government effectively subsidises (largely Democratic) high-tax states. The consequence of the change in SALT and mortgage interest deductibility will be to damage property values in those states and make low-tax states more attractive – but that is an unavoidable side-effect of removing distortions.
  • Second, the tax plan removes most households from being subjected to the AMT, and more households will choose not to itemise the mortgage interest deduction, reducing the distortionary federal subsidy for home-ownership.

What about the negatives?

  • First, the plan fails to meaningfully simplify the tax code. The AMT was retained (albeit at higher thresholds), and incentives for employees to reclassify themselves as corporations increased.
  • Second, initiating a deficit-funded fiscal boost at a time of full employment is hard to justify and imposes additional costs on future generations.  Indeed, a cynic might say that the tax plan sets the scene for a roll-back of entitlement spending programmes in future years.
  • Third, the income tax plan is undeniably regressive and will exacerbate social inequality, increasing the odds of future political extremism.
  • Fourth, the removal of the Individual Mandate will undermine healthcare insurance markets by worsening adverse selection, while doing little to reform and improve the provision of healthcare in the US.
  • Fifth, while the plan does increase incentives for business investment via temporary accelerated business investment deductions and lower corporate tax rates, the impact on productivity will in our view fall far short of what is required to increase trend GDP growth to 3%.
  • Sixth, the required cuts to discretionary spending in areas such as education and government research will likely damage workforce quality and economic productivity in the longer term.
Cedric Scholtes

Co-Head Inflation, Rates Committee Chair

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