Goldman On Tax Reform: “Now Comes The Hard Part”
The ink wasn’t even dry yet on the just published Republican Tax Cut And Jobs Act, and within the hour UBS was already confident that it has virtually no chance of passing: As UBS chief economist Seth Carpenter wrote shortly after the publication, “to our read, the release confirms our view that tax reform is far from being a done deal. The bill contains several specifics that we believe will prove sticking points, which increase the difficulty of finding the votes to support the plan in both the House and the Senate.” Fast forwarding to Carpenter’s conclusion: “We maintain our view that tax reform is unlikely this year or next.”
To be sure, banks have a right to be skeptical: after all with the economy already growing above 3%, the last thing financial institutions want is for another burst of output courtesy of fiscal stimulus. Last week, Lloyd Blankfein said as much when the Goldman CEO warned “now’s not the best time for tax cuts”, a view diametrically opposite that of his former “right hand man”, Gary Cohn, currently Trump’s chief economic advisor, who said this is precisely the right time for more tax cuts.
“I can’t say this is the moment where you want the most fiscal stimulus in the market, when we’re mostly at full employment, when GDP last registered at 3 percent,” Blankfein said Thursday in a Bloomberg Television interview. “I don’t know that this is the moment that you provide the biggest stimulus.”
Goldman CEO’s skepticism was obvious in a report released this afternoon by economic Alec Phillips, who looked at the tax plan released on Friday, and said that while Goldman still assigns a two-thirds chance of tax reform passing, it conceded that “now comes the hard part.”
First, here are the big picture details:
Tax Reform: Now Comes the Hard Part
- The recent release of the House tax reform bill marks the start of the second, harder, stage of tax reform. The plan cuts the corporate tax rate to 20% and reduces taxes on individual and “personal business” income while staying within the $1.5 trillion (over 10 years) cost limit recently agreed to in the House and Senate. Achieving all three goals had appeared quite difficult in our view but the proposal does it, according to the official estimates.
- The House proposal includes substantial reforms. However, this greater-than-expected base broadening has already generated some political opposition, which is likely to lead to changes to the House bill as it moves forward. The Senate is likely to release its own version with even greater differences within the next week or so, in our view.
- The proposed tax cut is more front-loaded than we have expected; official estimates suggest a tax cut of 0.75% of GDP in 2018. However, we expect the final version to have a smaller near-term effect as competing priorities lead tax-writers to phase in some cuts—particularly corporate rate cuts—over time. Senate Republican centrists have already expressed concerns about the cost and might balk at tax cuts that expire after five years, since the true ten- year fiscal cost would rise if they were extended.
- The net tax cut appears to be weighted more heavily toward individual and “pass-through” income than to the corporate sector. This is surprising considering the proposed immediate and permanent 20% corporate tax rate, but appears to be the result of substantial base-broadening, new restrictions on cross-border corporate activity, and the fact that several existing tax incentives are set to expire, which offsets a portion of the net tax cut under the legislation.
- We continue to believe that tax legislation has around a two-thirds chance of becoming law by early 2018. The release of the House legislation is a positive step in that it moves the process forward. It also demonstrates that meaningful base-broadening might be more achievable than we have believed. However, it does not alter our outlook for the odds of enactment, since the Senate is likely to release its own bill shortly and the vote in that chamber represents the greater obstacle to passing tax reform.
Hatzius lays out the key underlying details for his current outlook:
There are good reasons to believe that tax legislation will become law in the next few months and we believe there is a 65% chance of enactment by Q1 2018. First, tax reform—and a net tax cut—is an area where the President and most congressional Republicans generally agree. This is notable, since there are substantial differences within the Republican Party on a number of other issues, including immigration, infrastructure, international trade and health reform.
Second, congressional Republicans face a difficult midterm election in 2018 and many lawmakers believe Republican prospects would be improved by a major legislative achievement before voters head to the polls. As Exhibit 1 shows, Republicans tend to be more supportive of most of the general aspects of tax reform than Democratic voters, though some tax changes are more popular than others; middle-class tax cuts and small-business relief enjoys broad support, while corporate tax cuts do not.
Third, tax legislation can pass in the Senate with only 51 votes, instead of the customary 60 votes, through the budget reconciliation process. Now that a majority of the House and Senate have passed a budget resolution calling for a tax cut of up to $1.5 trillion over ten years, the odds would seem low that they would fail to follow through in passing the tax legislation itself.
Nevertheless, there are still a number of ways that the effort could run off the rails. First, tax reform is much harder than tax cuts. The recently introduced House proposal is a case in point. While the proposal achieves meaningful reductions in individual and corporate tax rates, it also targets a number of specific tax benefits and several important constituencies have come out against the bill. This is the main risk to passing tax reform with only Republican votes, in light of the slim Republican majorities in both chambers.
Second, although House and Senate majorities voted in favor of a budget resolution including an instruction to cut taxes by up to $1.5 trillion over ten years, a few of these lawmakers have expressed some hesitation regarding the tax legislation itself. Senator McCain (R-AZ), for example, has called for the legislation to be considered under “regular order” and might not support a tax bill passed via the reconciliation process. Senator Corker (R-TN) supported the budget resolution but has left open the possibility that he would oppose the tax bill itself if he feels it would add to the deficit beyond the estimated revenue gain from economic growth effects and the cost of extending expiring provisions.
Third, while few argue against the concept of revenue neutral reform that lowers statutory tax rates and broadens the tax base, there are good arguments against a large net tax cut at the moment, including a high debt-to-GDP ratio, growing fiscal imbalances projected over the coming decade, and an economy with little remaining slack. This stands in contrast to the 1981 and 2001 tax cuts, when the federal budget was projected to run surpluses, the debt-to-GDP ratio stood at less than half of its current level, and the economy was in recession.
That said, the tax cut is not that large; nearly $500 billion in expiring tax provisions were likely to be extended regardless of tax reform, so the net revenue loss over ten years compared to our and most other realistic projections is only around $1 trillion (0.4% of GDP). The increase in GDP that would result from a tax cut would reduce the net cost slightly further.
Next, Phillips breaks down the key components of the Tax Cut And Jobs Act, whose core principles are summarized as follows:
On November 2, the House Ways and Means Committee released its Tax Cuts and Jobs Act (TCJA). The proposal makes more substantial changes than are implied by its estimated cost. The House plan achieves a 20% corporate tax rate and tax relief for individuals and “personal business income” while staying within the $1.5 trillion (over 10 years) limitation on cost recently agreed to in the House and Senate. Achieving all three goals had appeared quite difficult but the proposal managed to do this, according to estimates from the Joint Committee on Taxation (JCT); the most recent estimate puts the total revenue loss at just over $1.4 trillion over ten years.
Here, instead of repeating Goldman’s take on all the core aspects of the TCJA, we summarize the progression of tax reform courtesy of the following summary chart:
Which the brings us to Goldman’s critical discussion on “the way forward”, or what happens next. Exhibit 8 below summarizes Goldman’s expectations regarding the timeline for consideration of tax reform over the next few months.
The House Ways and Means Committee is scheduled to begin its “mark up” of the TCJA on Monday, November 6. This is likely to take several days, and will involve the consideration of dozens (potentially over 100) amendments to the proposal, followed by a vote on the package as amended. House Republican leaders hope to pass the bill on the House floor the week of November 13, but might have to postpone the vote until after the Thanksgiving recess (the week of November 20) if there is insufficient support and further changes become necessary. In our view, there is little risk that the committee will fail to pass the bill, but a good chance that objections from some Republicans could delay passage by the full House until after Thanksgiving. That said, we believe there is a high probability of House passage by December.
How about the Senate?
The Senate Finance Committee might release its own proposal late in the week of November 6, though it is also quite possible this could be delayed. Although Senate Republican leaders have expressed hope that the Senate might be able to pass tax reform legislation by the end of November, this seems unlikely to us. Passage in December is certainly possible, however, in our view. We assume that a conference committee between the House and Senate will be necessary to resolve differences between the two bodies, which would probably delay final enactment until early 2018. That said, it is conceivable that the House could instead simply pass the Senate’s version of tax reform, which might allow for enactment before year-end. We continue to see enactment in early 2018 as the base case, though we note that market perceptions could shift substantially before then. For example, a successful Senate vote in December could lead market participants to place a high probability on eventual enactment, since the Senate vote is widely seen as the greatest risk to passage.
In summary, Goldman continues to believe there is a 65% chance that Congress will approve a tax bill by Q1 that results in a net tax cut of about $1 trillion (0.4% of GDP) over ten years (an amount similar to the tax cut under the TCJA, adjusting for scheduled expiration of tax incentives under current law) by Q1 2018. By comparison, prices in the online prediction market PredictIt imply a 60% probability that a corporate tax cut will be enacted by the end of Q1 2018, and around a 30% chance it would be enacted prior to year-end, down from over 80% early in the year.
What about the market?
The relative performance of our equity strategists’ basket of high tax stocks vs. the S&P 500 suggests that expectations have come down further. Even after adjusting for dollar depreciation—low tax stocks tend to have more foreign exposure so the relative performance might also be driven by the value of the dollar— the basket suggests that market expectations for tax reform that benefits high tax companies more than low-tax companies are not much greater now than they were prior to the election.
What may be taking place, according to Phillips, is that In light of the House proposal’s 20% rate combined with substantial base broadening and base-erosion protections, the market might soon assign a higher probability that the high tax rates faced by some companies— particularly those with a largely domestic focus— might converge with the low effective tax rates that some US-based multinationals pay. As a reminder, while the statutory US tax rate is 39%, the effective US tax rate of 27% has never been lower. In this light, the Trump tax cuts, contrary to Steven Mnuchin’s observations, will soon be seen as a non-event, especially if Goldman is correct, and the agreed upon corporate tax rate end up being 25%…