5 Actual 'Facts' About Tax Reform
Yesterday’s announcement regarding the White House plan on tax reform was a little short on details.
We’ll fill in a few of the gaps in this note – not about what the plan should be, but the numbers behind what it has to deliver. The most important point: corporate tax reform is much easier to accomplish than anything else because these receipts account for less than 10% of Federal government revenue. That’s a notional positive for equity markets.
A more troubling point: CBO baseline expectations for Individual Income Tax receipts over the next 10 years are for +5% (good luck finding a revenue neutral tax reform plan).
Also in the “Fact mix”: total taxes as a percent of GDP are remarkably sticky over time and the CBO projects widening deficits over the long term even under their rosy scenario.
Bottom line: investors want to see corporate tax reform (including repatriation relief) succeed. Individual tax reform is a “Nice to have” but negotiations there could derail the corporate side.
[ZH: Which is ironic given that it is the ‘personal’ rates that appear to need the adjustments…]
“You are what your record says you are.” Bill Parcells
Yesterday’s announcement on tax reform was a bit of a miss from the perspective of market expectations. It was strong on conviction (kudos to Steve Mnuchin and Gary Cohn there), but weak on details. In truth, this is a complex topic. As the Treasury Secretary rightly observed, US tax code is byzantine in the extreme.
At the same time, there are some simple numbers that can illuminate the contours of the debate. That Parcells quote at the top will guide us in this note. The record – how the US government actually raises revenues – speaks for itself.
Fact #1: Corporate income taxes are NOT a primary driver of Federal government revenues. That’s good news for equity markets, since corporate tax reform sits at the top of their Trump-onomics wish list.
- The Congressional Budget Office data shows that last fiscal year (2016), the US government received $300 billion from this source. Total receipts were $3,267 billion, making the percentage of inflows from domestic companies only 9.2%. Expected revenues this year total $320 billion against total revenues of $3,404 billion (9.4%).
- The percent of total Federal revenues from corporate income tax has not been over 15% since 1978 according to CBO data. The highwater mark since 1980 was 14.7% in 2006.
- The fact that corporate income taxes is a relatively small portion of the Federal revenue stream makes it easier to adjust these rates and maintain a neutral long term forecast for the budget deficit. Moreover, a lower repatriation tax on the estimated +$2 trillion of offshore corporate cash could go a long way to filling the hole left by lower ongoing statutory rates.
- All this is good news for equity markets, and I suspect one reason US stocks have been remarkably patient with the debate in Washington over tax reforms stems from the simple calculus I have laid out here. This piece is not that hard.
Fact #2: Where things get sticky is in the CBO’s “Baseline Budget Projections” for future “Individual Income Taxes” and “Payroll Taxes”.
- The CBO’s baseline expectations are that Individual Income Taxes will increase by a compounded annual growth rate of 5.1% over the next decade. The exact numbers (from the January 2017 CBO worksheets): $1,651 billion in 2017(e) to $2,714 billion in 2027. Given that US population growth is less than 1% and wage growth is most likely no better than 2-3%, this is a tall ask.
- Expectations for increases in receipts from “Payroll taxes” (withheld income taxes, Social Security and Medicare) run 3.6% annually over the next decade. The same caveats as the prior point apply here.
- Worth noting: CBO Baseline Budget Projections assume no recession in the next 10 years. And even then, they expect the percentage of “Debt held by the public” to rise from 77.0% to 88.9% by 2027 because of annual revenue shortfalls relative to government outlays.
- This is what makes the tax debate so difficult – any proposed changes to the tax code have to be revenue neutral so as not to increase what is already expected to be a growing deficit. Not only does the lawmaking process essentially require that (unless Democratic senators cross party lines) but the right wing of the Republican Party tends to be deficit hawks. There simply isn’t much room here.
Fact #3: The relationship between Federal revenues from taxes and GDP is remarkably stable, and we are currently running close to the long run average.
- Over the last 50 years, the average of Federal tax revenues as a percent of GDP has been 17.4%; last year (2016 Fiscal) the percentage was 17.8%, well within the 1.1 point standard deviation of the last 5 decades.
- Since 1967 the all-time high percentage was 20.0% (2000) and the low was 14.6% (2010 and 2011).
- When you consider all the different tax regimes over the last 50 years, this is a remarkable observation. Since the 1960s, for example, corporate taxes as a percentage of GDP have fallen from 4.1% (1967) to 1.6% (2016). We’ve had numerous attempts to change tax codes and rates over this timespan as well. And yet that 17-18% seems etched in stone.
Fact #4: The relationship between tax receipts/economic growth/equity market returns isn’t exactly what you think.
- During the 1970s, Individual and Payroll Taxes combined averaged 12.9% of GDP; during the Reagan years this figure was much higher 14.3%. In other words, more tax revenue flowed to the Federal government as a percent of economic output – not less. The 70s, of course, were a period of parlous equity market returns and economic growth. The Reagan years were much better, even with a greater percentage of taxes relative to economic growth.
- There were actually 2 rounds of tax cuts in the 1980s, in 1981 and 1986. The first was partially repealed 1982 when revenues declined as the result of recession, and there were several tweaks in subsequent years. The Tax Reform Act of 1986 furthered the reduction of individual taxes started in 1981, but was notionally revenue neutral because it reduced various loopholes and increased corporate taxes.
- The upshot is that tax reform can both increase revenues and economic growth, but the Reagan experience shows this is not a one-and-done process. Even the Gipper had to backpedal a little after the `1981 law passed, but eventually got his agenda across the goal line in 1986.
Fact #5 (Summary): When it comes to corporate earnings and cash utilization, and hence equity market performance, getting corporate tax reform matters more than anything else. Moreover, it is relatively simple because the numbers are smaller than Individual/Personal Tax reform. And the results – greater business confidence driven by certainty on the topic and lower tax rates – would be an unalloyed positive. Not to mention the onshoring of billions of dollars currently captured offshore….
But – and it’s a big “But” – corporate tax reform seems inextricably linked to individual tax reform. Here, the story gets complicated. CBO baseline estimates look unrealistically optimistic and dynamic scoring (taking into account the economic effects of tax code changes) is not exactly a science. Or an art… Even a tax plan crafted by an omniscient and caring Deity could fail CBO scoring, let alone one created by well-meaning bureaucrats.
In the end, Coach Parcells remains our guiding light on the issue of tax reform. The record is clear: lower taxes and simpler tax codes help economic growth. They are not, however, the only driver and other issues like Fed policy and business cycles can hijack the market’s attention (as it did in 1981). We’ve argued recently that “Trump Trade 1.0” is over (post-election “hope” bump) and Version 2.0 (actual results) is not yet here. Nothing about the tax reform initiative makes me feel confident that we’ll be downloading a new market narrative any time soon.