Tax Wake-up Call

By Rayna Penelova

After several months of debate and different versions of a healthcare bill, Congress failed to deliver on a major campaign promise this week. Yet, the stock market continues its march higher. Of course, there is a logical explanation. Even though a failure to pass healthcare reform is a setback, Republican lawmakers should now be even more motivated to deliver on their tax reform and fiscal stimulus promises, assuming they want to keep their jobs in 2019. So, House republicans are currently hard at work on their budget resolution, which currently calls for revenue neutrality. This is an important detail that has been overlooked by the media, as well as the stock market.

Paul Ryan, the speaker of the House, wants a permanent, pro-growth change to the tax code and under reconciliation rules, this would make revenue neutrality a requirement. This could be positive for the economy in the long term, as it could reconstruct the tax code in a way that makes it more business friendly and boosts growth. However, if it is revenue neutral it would have to increase taxes in some areas to decreasing them in others. This is sure to disappoint anyone who expects a significant net tax cut or fiscal stimulus package. In addition, it would limit the potential for a game-changing corporate tax or small business tax cut, as those would have to be offset by a large tax increase somewhere else. If proposals are created under this framework, there will be no net tax cut and no additional money in people’s pockets, and therefore no substantial short term boost to the economy.

On the other hand, President Trump is in favor of significant tax cuts that would have to sunset after several years, similar to what President Bush did. This type of plan cannot be permanent, as it would further increase the deficit, which is already projected to increase in the coming years. Any short-term tax cuts are likely to have a limited effect on economic growth. Businesses making long-term investment decisions would not only like a short-term boost to their earnings, or the ability to expense capital expenditures, but need visibility into their future tax expenses. The President’s plan will boost growth and profitability over the short term, and maybe even further extend the business cycle, but its effect will be limited and would not deliver on the long-anticipated and promised idea of comprehensive tax reform.

Despite all that, investors and commentators remain convinced of a tax cut, propelling markets higher. Over the past several months, I have read numerous reports by journalists, economists, and strategists, as well as some opinion polls on the topic of tax reform and tax cut expectations. Nearly all believe there will still be a meaningful tax cut that will provide a significant boost to businesses and the economy. In one of my previous blog posts I discussed the divergence between soft data (feel indicators) and hard data (act indicators). Confidence levels have decelerated since, but remain very elevated, while actual spending has not changed much. The main reason confidence is so high is because of the anticipation for tax cuts and reforms that boost the economy. This is very significant for stock investors, because confidence indicators are highly correlated with the stock market. If the tax legislation fails to reach the expectations of investors and business owners, we should expect a significant retracement in soft data, which could mean a tough period for equities.

Tags: Taxes

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