2017/09/28 Commentary: Trump Tax Tract
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Commentary: Thursday, September 28, 2017
Trump Tax Tract
It has been quite a week with far flung influences impacting all asset classes. In the first instance those include the US tax reform announcement that in part had such a strong impact due to the Republican Senate and House and the Trump administration collaborating on something ahead of time instead of hoping their leadership would coalesce around a core idea. The lack of that same sort of coordination was at least partially responsible for the failure of the Republicans healthcare insurance reform efforts, and there are hopes that it will be different with the even more important tax reform effort. And those hopes were amply reflected in the strength of the US equities and US dollar as well while weighing on the govvies; all due to the prospect of greater growth from the further encouragement for individuals to spend tax savings and businesses being expected to invest.
While we cannot argue with a proposition that has proven true again and again from the Kennedy era onward, this particular tax reform proposal has some internal contradictions along with political hurdles that are greater than previous efforts. So there are pros and cons where the cons are either especially troubling or outright ploys. While we will get back to a more extensive discussion below, it is important to note the most contentious of the ‘streamlining’ proposals that also raises quite a bit of the revenue to fund the overall tax cuts is the elimination of state and local income tax deductions.
On one hand, this is a rational adjustment. On a politically conservative philosophical level as well as a practical consideration, why should the rest of the country underwrite the revenue collected by those local governments? It is a direct cost to the rest of the country in the form of the greater revenues collected from other states. And yet….
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NOTE: REVISED 2017-08-31: Like many others, we were encouraged by the likelihood the US economy would get the structural reform we (along with Mario Draghi and others) had been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015. Since our December 8, 2015 Extended Perspective Commentary we were concerned about various factors that included continued high taxes and more regulation (i.e. under Clinton) that might have meant a continued weak, or even weaker, US economy. It was hoped Donald Trump’s election would change that. However, much like the estimable Ray Dalio (see our August 24th Commentary: Trump Troika post) and others, we are now very concerned that the US President’s diminished relationship with the Republican Congress will mean his tax reform and infrastructure spending agenda will have trouble getting passed into law. And that will quite possibly be a problem for any US economic acceleration, and high-priced US equities.
[Thanks to Tax Foundation for the opening graphic. © 2017 All Rights Reserved.]
▪ …as with the healthcare reform effort, it is the Senate that is most interesting due to the far more marginal Republican majority compared to the House. Deductibility of state and local taxes from federal tax bills is seen as a cost that is centered in high tax, politically liberal Democratic states (like New York, California, Minnesota, Oregon, etc.) Yet there are some glaring exceptions that also impact Republican senators. For more on the individual tax rates, simply click into the opening map.
Let’s get away from the most glaring high tax states like New York at 8.82% and California at a whopping 13.3% and focus on some other states with still high state income tax rates around 6.0% or higher. We chose 6.0% as the important threshold due to the large number of states with roughly at least that level of state income tax, and how prominent the overall Republican Senate presence is in those states. There is also how much it would cost the federal government to allow that deduction to be maintained as they try to justify the cost of the tax cuts in other areas.
Republican Challenge
Especially considering those with prominent Republican Senate presence, the picture is far from clear on maintaining this aspect of the ‘Trump tax tract’ (with tract of course meaning a very large area of indefinite extent… which this week’s tax ‘proposal’ most definitely is on the sheer outline lacking details.)
As a brief rundown on those states is Idaho (2 Senators), Montana (1), Iowa (2 including senior Senator Grassley), Missouri (1), Arkansas (2), Louisiana (2), Kentucky (2 including Senate Majority Leader McConnell), Tennessee (2), Georgia (2), South Carolina (2 including the estimable Lindsey Graham and Tim Scott), North Carolina (2), West Virginia (1) and, Maine (1.)
Let’s see, that’s 21, and does not include 1 Wisconsin Republican Senator in the person of Ron Johnson. He only managed a come-from-behind victory in 2016 that helped deliver the White House to Donald Trump, along with help from Wisconsin Speaker of the House Paul Ryan. And there are also the 2 Nebraska Republican Senators, Ben Sasse and Deb Fischer, the latter of whom is up for reelection in 2018. Are we to actually believe no more than two of these folks are going to object to this provision?
‘Straw Man’?
That would be astounding, and any more than two of them refusing to vote for the reform package due to this provision would eliminate the ability of the Republicans to pass it on their own with 50 Senate votes. That is possible due to the rule that Vice President Pence is also the President of the Senate, and can cast tie-breaking votes when necessary.
SO the inclusion of the elimination of state and local income tax deduction from federal taxes may like be nothing more than a reasonably cynical negotiating tactic. We say ‘reasonably’ because in the early phase of any negotiation it is reasonable for one side to throw in a ‘straw man’ (i.e. easily knocked down) or two. Those are points which it will be willing to cede later in order to claim they have given up something as part of a ‘compromise’; which is then of course not really a compromise at all, but only allowing the elimination of something they were not expecting to get in the first place.
Do It Without Democrats?
And yet, the Republicans claim that in spite of their very narrow Senate majority they can pass the reform program into legislation along narrow party lines: in other words without any help from any Democrats at all. That sounds both like the specious claim they made on health insurance reform, and is even more so the case on tax reform where the winners and losers will be that much more transparent. As noted above, does the Republican leadership really believe they can count on no more than two of their own demurring from voting for tax reform if it includes this elimination of state and local tax deductibility in the initial outline? For each Republican Senator who refuses to go along with that they need one more Democrat to cross the aisle and vote with them.
Then there is the obvious resistance the Democrats will put up to block that provision, especially considering both the major states it affect along with the broad range of other states also impacted. At the high end of state income tax levels are roughly 9.0%-13.0% in New York, California, Minnesota and Oregon (not even counting city sales taxes and income taxes in places like New York City’s 3.6%-3.9% levy.) And the range of additional Senate Democrat states includes roughly ten other states with income tax rates in at least that 6.0% zone.
Dem Discipline
This is where far more diligent and effective Democratic Party discipline comes into play from the top down. Even if there was any Democratic Senator who felt that philosophically or practically this elimination of lower jurisdiction income taxes should not be deductible, there would be an appeal from the Democratic Party leadership to not vote against the interest of so many of its most populous and prominent states.
And when we say ‘appeal’ we actually mean apply extensive electoral and financial ‘leverage’, and essentially threaten to ‘drop the hammer’ on anyone who agrees to cooperate with the Trump administration and Republican Congress; especially on this issue. This obviously comes in two forms.
The first is the lack of any election campaign reform support from senior party leaders at campaign events. And while the Democrats are having trouble raising as much as Republicans at present, there is also the threat of refusing to provide essential financial support during the next election campaign.
Almost Bizarre
So it is almost bizarre to think that there will be any Democrat defections to support the tax reform plan as long as it maintains that provision. And if the Republicans really wanted to allow themselves the latitude to pass tax reform without Democrats, is the administration and the Congressional leadership really going to stick with the removal of state and local tax deduction from federal tax bills considering the damage it will likely do to Republicans’ election prospects? Or was it just a ‘straw man’?
And yet, if they do decide to still allow that deduction as part of a ‘compromise’, then what about the additional money that will still need to be raised elsewhere in the tax plan to leave it ‘revenue neutral’? This smacks of the same sort of hubris that is one of the end results of the failure of the health insurance reform effort: the trillion dollars of expenditure that remains in the still in force Obamacare plan.
That is therefore money not available to use in the tax cutting effort. While Republicans and the Trump administration have made much of the degree to which tax reform was going to be easier than healthcare insurance reform, we and many others have noted it will not be because of funds freed up from the Obamacare plans after that reform effort has failed. That is why the Obamacare repeal and reform was tackled first, and its failure has a negative impact on the tax reform effort.
Other Pros and Cons
There are some real positive aspects outside of the likely backlash to the proposed elimination of the deductions noted above. And in fact there was a very good summary of this from Business Insider’s Bob Bryan in his Wednesday article IT’S HERE: All the details of Trump’s massive tax plan. Especially the concise breakdown of the key business and personal taxation changes on page two into the top of page three are very interesting and useful.
He notes that Trump has already given some ground for the sake of fiscal sanity and moved from his 15% corporate tax rate target to 20%. Yet National Economic Council Director Gary Cohn and other were clear earlier today that this was a bright line limit on the acceptable high end of corporate taxation. We shall see. And while they promised streamlining through elimination of some business tax deductions and incentives, there was almost no detail on this. And that is now an area of further contention within the Trump administration’s ‘simple’ plan.
However, there were obvious net positives on both the corporate and personal sides. The proposed one time repatriation tax rate for company profits currently held overseas is a sheer net positive. At least in the first year this will yield substantial additional tax revenues regardless of whether companies use the remaining funds for stock buy backs, dividend distributions or actually invest in expansion and training.
Personal Benefits
The personal tax rate changes are also clearly a net benefit to individuals, especially lower- and middle-income tax payers. While the lowest tax rate goes up from 10% to 12%, the relative doubling of the ‘standard deduction’ means that people do not begin paying taxes until they retain more money. As a rough example, a lower income couple earning $30,000.00 per year would get roughly a $1,000.00 tax reduction.
That seems to be a recurring theme even when moving up into the middle class income tax brackets. It is also enhanced for families with children by an expanded child tax credit of $1,000.00 that will not phase out until higher incomes levels than previous. There are also three simplified tax brackets, down from seven previous.
While the ‘middle class’ tax bracket has not been specified as yet, it will be taxed at 25%. That will represent at least a modest tax reduction for folks earning roughly $100,000 or more up until the $400,000 area; at least based on the current tax brackets likely to be subsumed into the new brackets.
Yet all of that will be different state by state, with the folks in states with the highest state income taxes possibly not seeing any overall tax reduction, or even being taxed more, if the state and local income tax deduction discussed above are indeed eliminated. That brings us back to just what a contentious fiscal and by extension political issue that will be through the process of these negotiations.
Market Quick Take
▪ As noted since late July, there was September S&P 500 future resistance into 2,475-80. That resistance was intensified in early August after the failure from above that area left a fresh weekly DOWN Closing Price Reversal (CPR.) That reinforced the importance of 2,475-80 resistance at which it failed repeatedly.
Yet that weekly DOWN CPR Tolerance at the 2,480.50 late-July trading high was overrun two weeks ago and is now the near term support, and the December S&P 500 future (now front month) has so far been unable to even break that far.
After the market was only able to put in a modest new high above last week’s 2,507 all-time high, the continued focus on the Trump tax reform plan is likely to keep the market firm for now. The next resistance is into the 2,525-30 weekly Oscillator threshold (MA-41 plus 130-135) next week. Interestingly that this was the Oscillator extension at which it stalled into 2,475-80 area in early August, with the increases in weekly MA-41 since then now also raising that resistance. Major extended Oscillator resistance (not seen since early March) is 2,555-60 next week.
▪ On the govvies, the December T-note future (front month since last Wednesday) slipping back below its 125-28 DOWN Break after several sessions holding on in that area looks weak again. Dropping below last week’s post-FOMC announcement 125-17 low makes the DOWN Break look more credible, and close attention must now be paid to the key next lower interim support in the 125-00/124-24 area.
For much more on this as well as the similar considerations for the Gilt and Bund also now approaching key lower supports, please see those Market Observations in the extended section of last Thursday’s “Commentary: Fear of Fed Redux” post that were updated last weekend.
▪ And as far as the US Dollar Index is concerned, as it has finally pushed above the 92.50 area at which it failed over the past two weeks, we suspected it might want push above the interim 93.00 congestion to retest the more prominent 94.00 area resistance. As that upside follow through is in evidence since Wednesday, we have every reason to expect it will continue at least somewhat higher.
The euro is leading the way down after the problematic German election results, with EUR/USD now retracing from its recent push above 1.2000 to back near the 1.17 and 1.16 area supports. And the greenback strength is across the board to one degree or another.
That especially includes the US dollar improving against all emerging currencies on the more upbeat tax reform prospects for the US economy, like into the early part of this year. Whether that maintains is also likely to be influenced by how the US tax reform debate progresses. Please see the various ETVs in the previous Market Observations from last weekend for further details on the key trend levels and momentum.
▪ The Extended Trend Assessment with full Market Observations will be updated after Friday’s US Close to fully assess how various markets perform in the wake of the further developments in Fed policy two full days after a major FOMC meeting. That is especially important in this case considering the contingencies the markets (especially the govvies and US dollar) are facing into Friday’s finish for the week.
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